Differentiate Between Good Debt & Bad Debt

(May 15th, 2007)

Debt has become something as common as a baseball game in America. It is so prevalent in our society, with people having 5-15 different credit cards in their wallet, and shoving these things to pay for the smallest of purchases. The American society has changed from a Cash -> Savings based society to a Credit -> Debt based society.

Take a look at some of these facts about Debt in America:

Facts about Debt in America

  • According to the Federal Reserve Board, debt in American households has reached the $2 trillion mark, excluding mortgage debt.
  • US households with atleast 1 credit card had $9000 debt per each credit card owned. So if a typical household owned 3 credit cards, they would be in $9000 x 3 = $27000 in debt.
  • According to the Bank of England, the consumer debt in UK has topped the £1-trillion mark.

The reason for such high growth of consumer debt? The answer is credit card companies! Previously, credit card companies issued credit only to responsible people who they knew will be able to repay their debts in a reasonable period of time. Now, credit card companies are shoving these cards to sub-prime borrowers who will continously charge up debt on these cards way beyond their means. I mean I used to see long tables full of credit cards on display at my first year in college. These lenders were targeting 18 year old 1st Year college students, who will indulge in impulse buying and rack up debt way beyond their means. And credit card companies love this fact! They know that if a young 18 year old racks up $20,000 worth of credit card debt, he will pretty much be locked in for life in paying off these debts. This means more and more interest revenue for the credit card companies.

In this article, we will show you the difference between Good Debt and Bad Debt. Here's a tabular summary:

Good Debt
Bad Debt
  • Mortgage loan
  • Business / Commercial Loan
  • Real Estate Loan (Home Equity Line of Credit
  • School Student Loan
  • Auto loan
  • Credit card debt
  • Store credit cards
  • Gambling debt

When you use the "Good Debt" we listed in the above table, you could build yourself a significant amount of wealth over the longer term, if you handle this debt right.

The Good Debt?

Eric Gelb, CEO of Gateway Financial Advisors and author of Getting Started in Asset Allocation quotes, "Good debt is investment debt that creates value; for example, student loans, real estate loans, home mortgages and business loans." 3DebtConsolidation.com also suggests taking up more debt that is tax-deductible (just like how issuing bonds and paying interest on these bonds is tax-deductible for the big corporations). Also, take up more debt that builds wealth over the longer term (for example a current mortgage loan on a house that is expected to go up in value over the next 10 years, so that you can sell the house and make a good profit - capital gain).

Robert D. Manning, a professor of finance at the Rochester Institute of Technology quotes, "If you take a home equity loan because you have 17 percent credit card, and you go with a 6 percent loan that's tax-deductible, that's good debt."

What do you make from all this? Buying a house that will go up in value or refinancing your current credit card debt at 18% with a home equity line of credit loan with 6% interest rate is good debt. Other forms of good debt are debts that are taken out to generate high returns on stock market investments, mutual funds, etc.

The Bad Debt?

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

For example, buying a 21' inch monitor for your computer for $1000 and putting it on your credit card is a form of bad debt. Why? Within 1-2 years, this monitor will be worth only $200. This means it has lost over 80% of its value in a matter of 2 years!! What's even worse, if you do not fully pay off your credit card balance of $1000 by the due date, you will be paying additional interest on this amount. For each month that you pay interest on that 21' inch monitor tv, it continues to lose value, while you are paying more and more for it ($1000 initial purchase charge + monthly interest).

3DebtConsolidation.com says "When you purchase clothes that are worth less than 50% of what you pay for them as soon as you walk out of that mall, and put it on your credit card, and pay interest on this credit card, that's bad debt!"

Use this as a rule of thumb:

If you're purchasing an item that will NOT go up in value, and you cannot afford to pay cash for it, then you really CANNOT afford it!

Store Credit Cards

People like to sign up for many Store Credit Cards thinking that if they make purchases on these store credit cards, they will be getting 10-20% off in discounts in almost all of their purchases. While this is true to some extent, most people do not realize that most of these savings will vanish away if they do not make immediate repayments on these store credit cards, with the excessively high interest rates that they charge.

David Bach, CEO of Finish Rich Inc., and author of The Finish Rich Workbook quotes, "You can open a store credit card account, and what they're not telling you is that after the first few months, the rate jumps to 20 percent or greater."

Auto Loan Debt -> Good or Bad Debt?

An Auto Loan taken out to buy a new car that gets better gas mileage than your old car could be a good form of debt. You have to do a cost-benefit analysis to figure that out. However, Bach quotes, "People borrow to buy cars before homes. and that's unfortunate. For most people, their first major loan is a car loan. That's guaranteed to go down in value. So you really want to borrow less. For example, instead of rushing out to borrow to buy a $50,000 BMW, you'd be better off buying a $25,000 car."

We take a paragraph out of this article -> Get Real and Get Out of Debt

Some people think that a car is an asset. Especially us the Afro community, we will quickly get inside a Chrysler 300 or a Mercedes and install $10,000 rims on it. Now let me tell you, in 5-10 years, that car is going to lose a tremendous value, I'm talking about almost 80% of the money you put on the car. You'd probably put down $10,000 - $15000 down payment on a Mercedes, especially if you have a FICO score of less than 650. Although the Mercedes costs only $50,000, you'd probably end up paying a total of $75000 with interest included! And especially if you have bad credit, you could see a rate of 15%!

You go figure, the money you've just put down, the $15000 will be lost. I remember getting my first car, it was a BMW 7 series. I was paying $650 a month payment on the car, after putting an initial $20,000 on the car! By the way, that same BMW 7 series i bought 8 years ago, sells for $8000 today! And i ended up paying twice on the car (the initial $20,000 down payment), because i financed at a rate of 22%! I went broke! A car is NOT an asset folks!

Mortgage Loan - Best Form of Good Debt

The best type of debt to borrow is a mortgage loan. Value of houses have increased 6.5% per year over the last 30 years. Since you cannot pay 100% cash for this house, you can take out a home mortgage loan. For example, say you purchased a $300,000 house in 2007. This house goes up 6.5% every year. What will the value of this house be in 2010?

Value of House in 2007 = $300,000
Increase in Value in 1 Year= (6.5% * 300,000) = $19500
Increase in Value in 3 years = $19,500 * 3 years = $58,500
Value of House in 2010 = $358,500

See how your wealth increased a whopping $58,500 in a matter of 3 years!? However, if you would have purchased that $50,000 BMW, you would have LOST atleast $25000 in a matter of 3 years! Which is better do you think? Eh?

About 40% of people in America are renters. Now here's what's surprising. Bach says, "The average renter has a median net worth of $4,000, and the average homeowner has a median net worth of about $150,000." And what's the best time to borrow a mortgage loan? Now! Why? Because of low interest mortgage loans (5% - 6%, 25 year fixed mortgages) or home refinance loans using your home equity line of credit.