Good Debt and Bad Debt

In the personal finance world, we have a little mantra you might have seen before. Debt is bad. But is that always the case? I would argue no. Of course, it is better to be debt free than have debt, but sometimes it is necessary to improve your life.

Really Bad Debt – Credit Cards

There is one type of debt that is always bad. That is credit card debt. If you use credit cards regularly, like I do, pay them off in full every month. If you follow that rule and keep your utilization ratio under about 20%, credit cards are not bad. If you carry a balance and make interest payments, that is bad.

Credit cards serve a purpose but can be dangerous when abused. If you can’t handle paying your card off in full every month, I would suggest avoiding credit cards. If you can handle it, use them for the rewards and credit score building.

P.S. Include overdraft lines of credit in this category. They usually have unreasonably high interest rates, just like most credit cards.

Bad Debt – Interest Only Loans

Interest only loans are self explanatory. They are loans, such as a mortgage or line of credit, with a minimum payment each month that only covers outstanding interest. This is bad.

Interest only loans are built for the banks to make a ton of money while providing virtually no benefit to the consumer. You are making no progress toward paying off the debt. These are designed to be long term debt traps for the average consumer and are incredibly profitable for banks.

If you have a loan like this, make sure to pay well over your interest only amount each month. The more you pay, the faster the loan goes away. If you can, it could be a good idea to re-structure the loan as a standard installment loan to give you a solid repayment schedule.

Not Good Debt – Second Mortgages and Home Equity Lines of Credit

Putting an extra lien on your house is probably not a good idea unless absolutely necessary. By adding a second loan, such as a second mortgage or home equity line of credit, backed by your primary residence, you are giving yourself two opportunities every month to screw up and end up in foreclosure.

For some people, these are truly short term loans to make a home improvement that will increase the value of their home in the long run. In that case, these are not bad as long as you are responsible and make full payments every month.

Neutral Debt – Student Debt

Student loans are not necessarily good or bad. It depends on how you treat them and how you got them. If you spent $80,000 at a private school to get a masters degree in social work that will return about $20,000 a year in salary, your big student loans will put you under pressure. If you need an extra $20,0000-$40,000 to pay for an undergraduate degree or masters degree that will lead to a job that pays well, you are using debt to your advantage.

Whatever your current situation is with student debt, always make the minimum payments. Commonly, student loans are your first interaction with installment loans with fixed monthly payments. It is an opportunity to start your credit on the right track. Make good decisions and build up your credit for long term success.

Maybe Good Debt – Auto Loan

Cars are depreciating assets. When I worked at a bank, I noticed that the hourly employees often had the nicest cars in the lot. The people making $10-$14 an hour had cars worth more than those making well over $50,000 per year.

This happened for the same reason the hourly people made less money, there were not as smart with their money for the long term, they focused on short term happiness. The managers had invested in education, which led to a higher paying job. They invested in homes (long term incentives) over flashy cars. At the same time the hourly workers had nicer cars, they also lived in small apartments rather than nice homes. (This is a generalization, not every employee on the management side or hourly side fit this description. Well over half did fit this description, so don’t yell at me in the comments for it.)

If you are buying a reasonable car that you need and you can’t afford a cash payment, auto loans are not necessarily bad. I had a car loan when I got my Toyota Corolla after my old hand-me-down car died. I could not purchase a reliable and safe vehicle without a loan, so it was worth it.

Good Debt – Principle Residence Mortgage Loan

Home ownership is a great way to build equity and stop paying rent to someone else, but only if handled responsibly. Missed payments, late payments, and payments that go beyond your means are all problems with mortgages.

However, if you have a loan on a home you can afford and you are responsible, mortgages are good debt. They build up your credit score and can lead to financial freedom. Always look at every angle in depth, but don’t shy away if the situation makes sense for you.

Bonus: Turing Bad Debt into Good Debt

If you own a home and are well on the way to paying it off, you might benefit from a debt rollup loan (I just made that term up). I have helped people structure loans like this in the past.

For example, a woman came in with $20,000 in credit card debt, $7,000 remaining on her auto loan, and $40,000 remaining on her home mortgage. That is $67,000 in total debt. It would have taken her about ten years and tens of thousands of dollars in interest to pay it all off.

Her home was worth about $250,000, which is well over her total debt load. She was able to pay off all other debt and have just one mortgage loan payment instead. This refinance and debt rollup saved her hundreds of dollars a month in payments and thousands of dollars in long term interest.

The math is not complex, so you can look at your own debt structure and find out if this is a good idea for you.

What do you think? Is all debt bad? Do you disagree with my categorizations? Please share your thoughts in the comments.