Good Debt versus Bad Debt

Here's one of those bits of personal finance "advice" that I hate -- that there's "good debt" and "bad debt." Wait a minute, I have to correct myself. I believe in good debt and bad debt. Bad debt is any debt you have and good debt is when you have no debt. ;-)

I know, everyone in the world except for Dave Ramsey and two or three other people disagree with me, but I'll tell you why I'm so anti-debt (even "good debt") later. For now, let's look at this piece from Money Central that gives several thoughts on good debt versus bad debt Here are the highlights:

• "When you buy something that goes down in value immediately, that's bad debt," says David Bach, CEO of Finish Rich Inc. and author of "The Finish Rich Workbook. "If it has no potential to increase in value, that's bad debt."

• "Good debt is investment debt that creates value; for example, student loans, real-estate loans, home mortgages and business loans," says Eric Gelb, CEO of Gateway Financial Advisors and author of "Getting Started in Asset Allocation.”

• Robert D. Manning, a professor of finance at the Rochester Institute of Technology, also recommends taking on debts that are tax-deductible and debts that produce more wealth in the long run.

• "If you are talking about reducing current debt, that's where it starts to get nuanced," says Manning. "If you take a home-equity loan because you have a 17% credit card, and you go with a 6% loan that's tax-deductible, that's good debt."

• These general rules of thumb set some clear delineations -- buying a home or refinancing to get rid of excessively high rates is usually good debt, as is generating debt to buy high-return stocks, bonds and other investments.

• The concept of bad debt comes in when discussing the purchase of disposable items or durable goods using high-interest credit cards and not paying the balance in full.

The piece goes on and on, offering thoughts on good debt versus bad debt, but I think you get the idea. Now, here are my thoughts:

1. I agree that there are some things it's ok to go into debt for -- such as a college education and a house. Why? A college education will pay you back many times over the amount you have to borrow and a house is usually a great investment (as long as you buy and pay for your house using a reasonable financial plan).

2. That said, I don't like being in debt as a lifestyle. On both college and housing, I'd recommend you keep your expenses low, plow as much as you can into debt repayment, and get out of debt as fast as you can. Pay off your loan in half the time or less if you can.

Yes, there are those who will talk about how they can earn more than the cost of the debt by investing, but from what I've seen, this is much more theory that reality. In fact, of all the people I've ever heard talk about how it's smart to have debt because they are only paying X% while they can earn X+%, I've never seen one actually do it. Besides, remember that when you make a debt payment, you've just made a GUARANTEED investment (by reducing the cost of your debt). When you invest, you may get that expected return and you may not.

3. Credit card debt of any kind is not to be tolerated. I'm ok with having credit cards, in fact, I would recommend you use cash-back credit cards (I made over $330 last year with a cash-back credit card plus saved a ton on car expenses with another credit card). But you should only use them for expenses already in your budget. And you should pay them off every month. If you can't do this, you're spending too much.

I realize that several of you my think this is old-fashioned, out-of-date, or too-conservative advice. Maybe it is. Then again, here's why I believe in it:

1. This is what I've done and it's one reason my net worth is well above average. Maybe there are other ways to go to get a good net worth, but those are theories to me. I KNOW this one works.

2. I know the freedom that's associated with being debt free. Believe me, it feels good.

Comments

[Joe]

Instead of "good debt, bad debt", how about "bad debt, worse debt"? Or "tolerable debt, bad debt"?

[Duane Gran]

No debt is really good, since even under the best circumstances the return is always less than zero, but without a doubt some debt is worse than others. It is sort of like trying to figure out if it is better to be punched in the face or the gut.

For many people who are on a treadmill of financing day to day purchases it might be useful for them to make an incremental improvement from credit cards to a home equity loan. Maybe the same person can, with discipline, make the move from paying interest to collecting it through investing.

[FMF]

"It is sort of like trying to figure out if it is better to be punched in the face or the gut."

I LOVE that!!! ;-)

[Frank]

What if you could borrow money @ 2% fixed for ten years. And you took those poroceeds and bought a 10yr treasury earning 5%.

Is it bad debt to earn a risk free 3% spread? This is completely hypothetical and not currently possible.

But would you consider this bad debt?

[Nick]

I totally agree with you on this point. When I read in the Standard and Poor's Guide to Personal Finance that there was such a thing as bad debt, I was shocked. I even wrote about it on my blog. I have a personal enmity for any kind of debt. I hate owing money. It's a burden and an unnecessary stress if I've ever heard of one.

Good post today, I really enjoyed it, and I'm looking forward to winning a book later.

[Joe]

That's a good point Frank. And it's not completely hypothetical. Many of us get 12-month 0% or 2% credit card offers. If we maxed out a credit card with such an offer, and not put any other debt on that credit card, and used the cash to buy a 12-month CD at 5% (current rates), would that be bad debt? Of course, being very disciplined in paying the minimum payment every month. This is something that many of us could do today. But a fair argument would be that "this isn't the point", that the point is "to get and stay out of debt".

[FMF]

Frank --

Here's the part of the idea that doesn't work for me:

It's "completely hypothetical."

This is the same thought I had when I wrote:

"Yes, there are those who will talk about how they can earn more than the cost of the debt by investing, but from what I've seen, this is much more theory that reality. In fact, of all the people I've ever heard talk about how it's smart to have debt because they are only paying X% while they can earn X+%, I've never seen one actually do it. Besides, remember that when you make a debt payment, you've just made a GUARANTEED investment (by reducing the cost of your debt). When you invest, you may get that expected return and you may not."

So:

1. I've never seen anyone actually do what you're suggesting with any sort of discipline.

2. Maintaining/servicing debt is a hassle and time-consuming.

3. Is it worth it for 2-3%? Not likely. You can probably gain much more in other areas of your finances by spending the time there.

[Flexo]

Frank,

That's a good point, but it's not completely risk free. There is still the risk of running into personal problems -- losing a job, for example. Unless you have a solid emergency fund in addition to what's invested in the treasury, you'll start running into trouble quickly.

Bad debt and worse debt is a good way to look at it. I wouldn't recommend leveraging debt to invest in higher-return investments unless someone is extremely disciplined to do so and is on solid financial footing already. It's not a way to "get ahead."

[Jerry Kindall]

I currently have about $11,000 in an HSBC savings account that I have borrowed at 0% from credit cards. It does take some discipline and organization. It'd not be a good idea for me had I not had some credit problems in the past and been forced to go cash-only for a few years. I'm no longer in the habit of spending money I don't have, or at least will have this month, and I don't intend to get back into it. I do have other savings to cover expenses for six months if I should lose my job for some reason, plus I can draw on my Roth IRA if that's not enough.

My FICO score has taken a hit from this, admittedly, since I'm running at or near my limit on several cards. But I don't need to apply for more new credit right now -- and if I did, I can "buy" it by forfeiting some future interest and paying off the cards now.

I'll make about $500 in interest this year from doing this, which doesn't sound like much, I suppose, but I think of it as a tenth (after taxes) of next year's Roth IRA contribution.

[Eryka]

You aren't making 550 in interest. You have to deduct interest taxes. I too was going to carry student loans while stockpiling debt in high interest savings, cds and treasury bonds, but then I calculated how much I would have after taxes, and the spread is not that attractive when you calculate the risk of continuing to carry debt.

I have to admit that listening to daveramsey has converted my thinking on student loans. Luckliy the only debt I have is the student loans.

[Warren]

I am considering getting a business loan to expand my business. I don't need the interest deduction in general but of course I'd prefer the lowest rate. Do I have to deduct the interest? Can I get a loan from a lender and NOT declare the interest so the lender doesn't have to declare the income and therefore lower my rate?

Thanks for any insight on if this is legal and what the IRS might rule on it.

[FMF]

Warren --

The lender has to declare income from the interest regardless of whether or not you deduct it on your taxes.