The Difference Between Good Debt and Bad Debt

As you may have heard me say before, there is such as thing as “good” debt. It’s not something that comes up often this early in your life, but there is such a thing. People pull student loans, car loans, run up credit card debt, and heedlessly borrow and spend without giving a second thought to it. It’s a good thing that most banks give a limit to how much you can borrow, because otherwise, many people would end up defaulting on their loans and the banks will suffer a loss.

It’s important to know the difference between good debt and bad debt. Not only so that you may be more careful with what you invest your money in now, but also so you may know what would prove to be a good investments later on in life. So what makes good debt good and bad debt bad?

Good Debt

An important marketing term that businesses use is ROI, or return on investment. In order for a business to grow, they must make investments into their company, and many times, that involves borrowing money to put enough money into that investment to make a substantial return. It’s all about making your money work harder for you. It’s a risk, but business owners and corporate executives don’t make these kinds of investments unless they’re either certain they’ll make money back that exceeds how much they spent or if they have something else to back it up to cover the loss.

For you, you don’t necessarily have to use spreadsheets and marketing terms to make important financial decisions, but you should have this in mind whenever you make the decision to borrow money. Good debt is anything that you buy that would be a necessity and improves your productivity. The more common examples would be mortgage, student loans, and financing a vehicle.

Now it’s unlikely you’ll be paying mortgage any time soon and the only car financing you’ll be doing is putting money into repairing the car you bought off that used car dealer. Student loans would be more likely something that you’ll be getting into since it’s unlikely you’ll be able to pay off college expenses. In the past, I’ve said to never pull loans, and I still believe you shouldn’t have to resort to it, but there are exceptions to that rule. If you were to take the mindset of a businessman and ask yourself “will this generate enough income to justify the expense?” then you can come to an informed conclusion as to whether or not it would be a good financial decision.

Bad Debt

Traditionally, bad debt would be considering any debt that one would accrue through the use of a credit card. It’s a little more complex than that, of course, but generally speaking, if the particular item that you want to “invest” in could be paid with cash, pay with cash. The reason why mortgage would be considered good debt is because a home’s value increase with time. But with disposable items, on the other hand, their value depreciates over time.

Depreciable items, or goods that lose value over time, may include electronics, clothing, furniture, or anything the sort. Things that, of course, aren’t totally necessary, lose value, and don’t give you any direct form of return. Some even consider pulling auto loans bad debt, because the car’s suddenly worth a lot less the moment it’s driven off the lot. Although if you were to refer back to the definition of good debt, that line between good debt and bad debt can be blurred a little.

For instance you may invest in a new laptop to improve your productivity at work or buy a new car to create a more reliable means of transportation. A businessman may even buy a new suit or new furniture for one’s office to add to his or her prestige. The benefits may not be calculable, and even though such purchases depreciate in value, they still have a positive effect in terms of your career success.

But by the same token, things that would normally be considered good debt can be bad debt. Confused yet? Good.

An excellent example would be student loans. While in many cases a college degree can insure you a higher salary, not all are worth the cost. The biggest issue would be job security, as some career fields don’t have enough jobs to keep up with the demand. Another thing too is that not all employers require that you have a degree up front, and sometimes,  they could care less what you major in; as long as you have the experience they need and continue in a work-study program if need be, then you should be fine.

The problem many students have is that they really don’t know what they want to do. They try to get into the most prestigious university they can get into, and once they get there, they spin around in circles trying to figure out what it is they want to major in. Six years later, they end up with nothing more than a degree in Psychology and $100,000 in loans to pay off.

If you were to go back to the original question of “will this generate enough income to justify the expense?” you’ll find that many of the options out there for degrees and colleges really aren’t worth it. Chances are, all you’ll really need to get a job is a business degree from a 4-year state college and good communication skills. Sometimes, what you desire to do may not even require a degree at all. Deciding whether pulling loans is a good or bad financial decision all comes down to doing your research and coming to an informed conclusion.