When Debt is a GOOD Thing

The is an article I wrote some time ago--still very timely--about how we handle debt and buying on credit.  (originally posted on Helium at www.Helium.com)

Good Debt vs. Bad Debt

Our society is carrying way too much debt. We're drowning in it. It's no surprise that studies reveal debt is a destructive force on society, marriages, and even individual health and well being.¹  Yet, in personal finance there is a concept of good debt and bad debt.

Good debt? How can that be?  In most people's minds, debt is usually "bad" or  worse, but for the sake of this discussion, we'll use the concepts of "good debt" and "bad debt".

 Good debt is widely accepted to be debt that creates value or produces wealth in the long run.²   Factors that might also push debt over to the "good" side are whether that debt is tax deductible, or will help reduce currently existing "bad" debt.

 Debt that creates value might include student loans, real estate loans/mortgages, business loans, and purchase of income-producing equipment.  A student loan, for example, creates value by contributing to the life-long earning power of the borrower.  A mortgage used to purchase property, which generally appreciates over time, creates value well beyond the cost of borrowing. An entrepreneur with a good business plan would find it difficult to start a profitable business without the ability to finance the start-up costs. And many businesses or individuals would be hindered from growth and increasing profits without the ability to finance the purchase of equipment needed to produce an income.

 Debt that is tax-deductible is less expensive than other forms of debt because the interest paid is largely offset by the tax benefit received. A debt consolidation loan which effectively reduces the interest paid and the length of repayment may be considered "good debt" because it contributes creates value by reducing debt; building wealth over the long term.

 How do we define "bad debt"?  Anything purchased with debt that immediately loses value would be bad debt.³   So, too, would be debt to purchase something that has no potential to increase in value; like a toaster, or a pair of sneakers.  Purchasing disposable or consumable items, like diapers, or groceries, or eating out on credit is always "bad" debt if it is not paid off within the same billing cycle. An easy rule of thumb is that any debt that will outlast the item it is used to purchase is bad debt.⁴ 

 A difficult purchase to evaluate is the purchase of an automobile on credit.  A brand new car is generally "bad debt" because it loses value just by driving it off the lot.  Buying a needed car to get to and from work, or one that has decidedly better gas mileage and lower repair costs could be considered good debt, since it contributes to a better overall financial picture.  The problem of many is that they need a car, and they go into farther into debt than is necessary to buy a car that is bigger and better than what they need, because it is what they want and they  can "afford" the payments.

 Using credit and having debt can be a tool to wealth, or to financial destruction. Know the difference; use wisdom in evaluating your purchases to determine if they are "good debt" or "bad" and you'll be on your way to building a better financial future.

 ¹Barbara O'Neill, Ph.D., CFP, CFPC, AFC, CHC, CFCS, Specialist in Financial Resource Management, Rutgers Cooperative Research and Extension, New Brunswick, NJ

 ²Eric Gelb, CEO of Gateway Financial Advisors and author of "Getting Started in Asset Allocation

³David Bach, CEO of Finish Rich Inc. and author of "The Finish Rich Workbook"

⁴Bert Whitehead, MBA, JD, Alliance of Cambridge Advisors, Franklin, MI