Good Debt vs. Bad Debt

Ask most people on the street if debt is good or bad, and they will likely tell you that debt is bad, plain and simple. However, this is only partially true. In fact, there are different kinds of debt, and not all debt is necessarily bad. In general, debt can be divided into two main groups: good debt and bad debt.

Good Debt is debt that is used to finance new sources of income. For example, a loan to purchase an apartment building to provides rental income could be classified as good debt. Or getting a loan to start a business might also be considered good debt. This does not mean that you should just get a huge loan and go buy apartments.

By taking out an extra loan to finance an investment, you are also taking on more risk. If the investment goes bad, you will owe even more money than you did before the investment. In other words, debt can create a sort of financial lever. If the investment pays off, it will amplify your earnings. But if the investment fails, the debt will also increase your losses. You must do some research to determine if the potential reward is worth the risk.

Bad debt is the type of debt you usually hear people talk about when they discuss debt. Bad debt is debt that has little to no potential for making more money than you started with, and usually ends up as a loss. If you get a loan to buy a new car, that is bad debt. Buying a new stereo system and putting on your credit card is also bad debt.

In general, there are a few types of debt that are virtually always bad:

  • Credit cards.  Even a “good” rate on a credit card is still very high. Credit cards aren’t always a bad thing, as we will discuss later, but the debt that goes onto them is almost always bad debt.
  • Payday loans. Payday loans have very high interest rates, and are not good debt. Period. Stay away from these loans.
  • Car Loans.  Car loans are also bad debt. Cars decrease in value very quickly, especially new cars, and are not a place to invest to build wealth. If you need a car, fine. Just realize that it will not make money for you, and plan accordingly.

What about home loans? Buying a house will require a substantial amount of money, and most people will need a loan if they ever want to buy a home. But does a home loan fall under good debt or bad debt? This is a point of debate between financial advisors, because it is not a clear yes or no.

Some people, most notably Robert Kiyosaki, argue that home loans are bad debt, because the house doesn’t create any income. That, plus maintenance costs, insurance, and other expenses, make the house a money sink.

Others, however, claim that your house is your greatest asset, because those house payments are being turned into value in the form of a house. The house can then be sold for a profit if property values go up.

In the end, it depends on why you are buying the house in the first place. If you are buying it solely as an investment to fix it up and resell it, then it could be considered good debt. But if you just want a place to live, then it is probably bad debt.

By understanding the difference between good debt and bad debt, you can make smarter decisions about when to get a loan or when to just save your money.