Good Debt vs. Bad Debt and How Good Debt Can Help You
October 29, 2021
When it comes to personal finance, debt is often demonized, portrayed as something to be avoided at all costs. Generally speaking, no one wants to owe money (or pay interest!) if they don’t have to.
In reality, however, debt is often unavoidable. Most of us face costs in life that we’re simply not equipped to cover, whether it’s buying a home or car, paying for post-secondary education, or financing the cost of a new business venture.
While some may legitimately struggle to view the idea of any debt as ‘good,’ the fact is that some debt is necessary, and may ultimately be financially beneficial, as long as it’s managed and repaid properly. Needless to say, no debt that can’t be paid back on time, or worse still, not at all, should ever be considered ‘good.’
Some debts, however, truly deserve their rotten reputation, and are undoubtedly ‘bad.’ For example, there’s nothing to like about credit card debt, with punitive interest rates that can quickly turn a tiny balance into a big problem. Likewise, taking on debt to acquire a depreciating asset, such as a vehicle, doesn’t tend to provide much, if any, long-term financial benefit to the borrower.
What are some examples of good debts?
As the old saying goes, ‘It takes money to make money.’ If you haven’t got a lot of money, the best alternative is to borrow wisely and turn debt into opportunity.
The most common kind of good debt is mortgage debt. While property price fluctuations mean there’s always an element of risk involved, an overwhelming majority of homeowners enjoy financial success by following a simple formula: borrow to cover the purchase cost, live in the home for decades while responsibly paying back your mortgage, then eventually sell the property at a profit. As you pay back a mortgage, you build equity in your home, increasing the value of your personal stake. It’s the direct opposite of renting, where your monthly payments do nothing but line someone else’s pockets.
Investing in yourself is also considered good debt. A good example is borrowing to cover the cost of training or education. By and large, the better educated a person is, the more likely they are to find employment. Higher levels of educational attainment are also linked to higher levels of salary. Thus, the short-term debt required to fund an education will typically be paid back many times over through years of gainful employment.
Borrowing to launch a business venture, while sometimes a risky proposition, can also lead to long-term benefits, both financial and personal. Many small business owners are invigorated by the challenge of being their own boss, especially when they are able to apply their personal passions in a professional setting. While some businesses fail, others find success their founders never anticipated, more than justifying the cost of whatever borrowing was necessary to get the venture off the ground.
One final benefit worth mentioning: managing good debt properly can lead to better borrowing privileges. People who demonstrate a history of responsible debt repayment are likely to see that behaviour reflected in an increased credit score, which in turn makes it easier for that person to borrow at more favourable rates and terms in the future.
What kinds of debt are considered bad?
If you’re borrowing money to buy something that won’t generate income or appreciate in value, then your bad debt alarm bells should start ringing.
The best example is credit card debt. As long as you always pay your monthly balance in full, buying items with a credit card is convenient and relatively painless. As soon as you start carrying a balance, however, hefty double-digit interest rates will rapidly inflate the amount you owe and could bury you under an avalanche of debt. If you’re constantly ringing up big bills on clothes, electronics, or other consumer goods, consider cutting up your cards and only using cash for such purchases – it’ll prevent you from spending beyond your means.
While it’s not always easy to get around without a car, borrowing money to buy one isn’t much of a recipe for financial success. Whether new or used, vehicles typically depreciate in value as soon as they leave the lot, even though the amount owing on the purchase stays exactly the same. Of course, many people use their vehicle to commute to a job or use it to generate income. Although this mitigates the impact of the debt, it doesn’t change the fact that the asset is virtually guaranteed to decline in value before the debt is anywhere close to paid off.