What Is Good Debt? What Is Bad Debt?

Looking at the difference between good debt and bad debt and giving you ways to teach your kids

“Never risk what you have and need for what you don’t have and don’t need.”

-Warren Buffett

With everyone seeking to live a different life how do we apply the same money rules for everyone?

The answer, we believe, is that we can’t and that is why one of our founding principles here at Future Funders is that there are truly no uniform financial rules for everybody.

We all must learn to use money as a tool to live the lives we each want to live and that may be radically different for two people.

For example, let’s say person one wants to live in an expensive city, own a big house and nice things and have a big family. Person two wants to travel the world, is not sure about kids, and prefers small towns to big cities.

Both of these people will use money as a tool differently in their lives and who are we to say that the way Person one uses money is the “right” way or visa versa.

When it comes to the topic of debt or credit, this is no different.

Debt is just another tool that we can use to live the life we want to live. Not all debt is “bad,” but not all debt is “good,” either. It depends in our mind on what you intend to use it for and how a particular type of debt fits within the bigger picture of the live you want to live.

Below we review some of the most common forms of debt that we accumulate throughout our life and talk about some of the pluses and minuses to each.

For the below examples, we focus entirely on the return on investment perspective (defined in more detail here) of debt but acknowledge that return on investment is not the only consideration when taking on debt (i.e. taking on debt to help a loved one if there is no other option may not be a good return on investment but is nevertheless very important and likely worth it).

Ok, lets get to it!

Credit Card Debt

Credit card debt is typically short term in nature, used buy a lot of the things we need (or don’t need) day to day and then paid off at a later date.

In 2019, American’s saw a record high in credit card debt and delinquency rates with the young hit harder in terms of delinquency rates or lack of payment 90 days or longer (we would argue due to lack of financial literacy education).

On the positive side, if we regularly use a credit card debt instead of cash, or have multiple cards and remember to pay them off (or at least keep our utilization under 30%) this can positively help our credit score.

On the negative side, if we rack up too much spending and are lackluster in paying it off, interest can pile up quickly negatively affecting our credit score as well as our overall financial situation.

For this reason, we recommend keeping a budget (we have a free downloadable tool on our tools page) and really getting to understand the fine print of each card you own (what are the benefits, what are the penalties).

For a helpful look at different cards and card options check out Nerdwallet.

Mortgage Debt

When we go to buy a house, most of us will take out a mortgage, or get a loan from a bank. If you live in an area that is seeing population growth (i.e. more people moving in than out over years), there is reason to believe that your house will rise in value over time (disclaimer: there are a lot of factors around homes value but this can be used as a rough long term guidepost).

In this case, debt can be a positive if your home is rising in value over time above the borrowing rate on debt. For example, lets say you have a mortgage at a 5% fixed rate but you feel confident over the next 10, 20, 30 years your home’s value will rise by more than 5% a year (and you can handle a 5% mortgage in your budget even under negative scenarios).

Well, in that case we would argue mortgage debt can be considered “good debt,” because while you are borrowing money and have to pay 5% each year, you are earning more than 5% each year by the value of your home going up.

If the reverse of the above is true and you live in an area where you are less confident in people wanting to move there over time and in turn less confident that the home value can rise above 5% a year, then we would consider this “bad debt,” as you are paying more in interest each year than the return you are getting from that money.

To check out our handy mortgage calculator and think about how much home you can afford click here.

Student Loans

Student loans are a very common form of debt most people will encounter in order to go to college. The amount is eye popping, with almost $1.8 trillion (yes, trillion with a T) total student loan debt outstanding in the United States.

The average balance is nearly $40,000 and with the average salary in the United States just over $50,000. after people pay for taxes and living expenses there is typically not much left over to pay down student loans.

While our current view places most of the fault in the bloated cost of higher education and agree with many who say our current education model is not sustainable, when thinking about student loan debt as a type of debt, we think that a lot of it depends on how you are going to use it.

On the positive side, we believe that investing in yourself is one of the best things a person can do with his or her money, and getting a degree that can help you move toward living the life you want to live can have intangible benefits and pay you back at a later date with a higher earning potential, higher amount of happiness, or both.

On the negative side, if you are aimlessly looking to get a degree for a piece of paper and it is accompanied by a lower return (i.e. studying a subject that will he harder to use it to earn money at a high tuition cost), this can be a poor use of debt.

Without the ability to return more money to you at a later date above the interest rate you are going to pay for the debt, you have to be very careful about using too much of this kind of debt.

Auto Loans

When it comes to Auto loans, similar to a lot of the above, be careful with how you use these.

Taking on too much debt to buy that expensive car you don’t need may not be the best option (although it might be if that is truly what you want for other reasons and are comfortable with the payments).

If you are using or renting out your car to earn money (yes, there are people that do this), or using it to drive for a company, they using a loan to buy the car may actually be a good investment.

The key questions is are you earning a return over what you would pay to service the debt.

Final Thoughts…

When taking out any kind of debt it is important to ask yourself two questions to think about whether it can be considered good debt or bad debt.

Number one, will the debt pay for itself?

Whether it is a mortgage loan, student loan, auto loan, or other loan, will the return you are getting outweigh the interest you will have to pay on the debt.

Number two, are you ok to handle the interest payments in scenarios where that is not the case?

This is the one most people forget when handling debt, and why some people who have had a bad experience in their life with debt choose to be more conservative (nothing wrong with that!). You need to be sure that when taking out the debt even in tougher circumstances that you can handle the payments.