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Good Debt versus Bad Debt

Updated on December 8, 2011

Many people have a negative attitude toward debt; however, not all debt is inherently bad. In fact, when used properly, debt can be very beneficial. Most people cannot pay cash for everything they buy, like a house or a car. This inability creates the need for debt, and to have solid finances, it is very important for people to understand the difference between “good” debt and “bad” debt.

Bad Debt

A simple rule of thumb that I use is: Do not borrow money for anything that you cannot afford and is not a solid investment. Take a look at the following list for examples of bad debt:

· Long term credit card debt for a vacation

· Auto loan on a luxury car

· Mortgage on a house you can’t afford

· Long term credit card debt for new furniture

The similarities between all these types of debt are that the items purchased were not affordable and were not solid investments. While they may provide enjoyment in the present, they are bound to bring about heartache in the future. $4,000 worth of new furniture that you cannot afford today could end up costing tons more down the road. Let’s take a look at a quick example (assuming the average credit card rate of 16.75%):

As you can see, by only making the minimum payment each month, it would take 26 years to pay for the furniture and cost an additional $7,659 in interest. Even by making a payment of $150 each month, it would take 3 years to pay for the furniture and cost an additional $1,039 in interest.

Good Debt

As I mentioned before, there is such a thing as good debt. Opposite bad debt, good debt is incurred in the process of making a solid investment. Rule of thumb: If you can earn a higher return on your money than the interest on a loan: borrow the money! Here are some examples of good debt (assuming you have decent credit):

· Student loan

· Mortgage on an affordable house

· Auto loan on a practical car

· Interest free loan on new furniture that you can afford

Let’s go over an example of incurring good debt on the purchase of a practical car. A practical car is a good investment because it allows someone to get to and from work, it loses less value than a luxury car, and it can save on transportation costs if public transportation is expensive or not efficient where you live. Many people cannot afford to pay cash for a car, so they must take out an auto loan regardless. However, even if you can pay cash for a car, it may make better financial sense to take out an auto loan.

For example, there are many deals going around today for a 48 month auto loan at a 1.99% interest rate. For a $15,000 car, a buyer could either pay $15,000 today or take the loan and end up paying $15,618 after 48 months of payments. By choosing the second option, the buyer would be able to invest the $15,000 today and pay for the car over time. Let’s assume a moderate annual rate of return of 6% (the average annual stock market return is around 8%):

As you can see, by taking the loan, even though you could pay cash for the vehicle, you could make about $1,455 in the 48 months it takes to pay back the loan.

Tax Incentives

Whenever you decide whether or not you want to take a loan, you must also consider the tax benefits that some loans, such as home mortgages and student loans contain. With these types of loans, the interest payments are tax deductible. Therefore, if your tax rate is 25% and the interest rate on a mortgage is 4%, after accounting for the tax incentives, your actual interest rate is only: (100% - 25%) * 4% = 3%!

Conclusion

There is such a thing as good debt and when deciding whether or not to borrow money, the following factors should be considered:

  1. Is the loan for something that is a solid investment?
  2. Is the interest rate lower than the rate of return you could earn on the money?
  3. What are the tax incentives to taking the particular loan?

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