What's the Difference Between Good and Bad Debt?
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Debt has a bad name—and for good reason. It can be a major barrier to wealth, siphoning resources and energy you could be devoting to other goals, like saving for a dream vacation or plumping up your 401(k). But contrary to what you may have heard, debt isn’t all bad. Rather, debt is a tool that can be used in good or bad ways.

One way to tell the difference is to explore the relationship between money and time. For example, taking out a mortgage essentially allows you to “time shift” your income. If it made sense to save up and buy the house outright, you might do that. But then you wouldn’t get to raise your family in that home; instead, you’d wait until your 50s or 60s to move in. So you trade money for time—paying a little extra (in the form of interest) for the privilege of using money you haven’t earned yet.

The same holds true for student loans. If you can, say, borrow $40,000 at 18 to go to college and score a $50,000 salary at 22, you’ve time shifted and added in the element of investment. (You’re earning more than you borrowed, and, ideally, than you could have earned without the degree.)

Of course, profitable returns aren’t guaranteed. Overpay for a home or borrow at a high interest rate, and you’ll lose money. Borrow too much or get a degree that doesn’t help you land a good-paying job, and you’re stuck with bad debt you’re struggling to pay off.

How can you decide before borrowing if you’re about to land in good or bad debt? We’ve analyzed the four most common debts to help you figure it out.

Student Loans

Another important factor in the good versus bad debt debate is how much you pay to time shift. Let’s call the difference “cheap money” versus “expensive money.”

Federal student loans typically have a fixed rate of 6.8 percent or less. This rate is nearly always cheaper than what you’ll find with private loans from banks. Therefore, we can generally consider federal loans good debt.

However, there’s some nuance once you consider debt load. Students who borrow far more than their post-college income end up with bad debt, even if the money was cheap. And those who end up with high incomes can reasonably consider their expensive private loans worth it.

Education funding expert Mark Kantrowitz came up with a formula to help borrowers determine how much debt is too much, which boils down to this: Don’t borrow more than you can repay within 10 years, using half the income boost you’d expect from your degree. For example, if a bachelor’s degree would net you $45,000 in your field, compared to $30,000 you’d earn with a high school diploma, that’s a $9,000 annual “college degree gain” after taxes. Half is $4,500, which is enough to service the average load of $35,000 over 10 years (including interest owed).

As a simpler guideline, Kantrowitz recommends not borrowing more than your expected first-year salary. That way, you can roughly pay off the debt using 10 percent of your income over 10 years. Anything more than that is probably bad debt.


For the vast majority of consumers, mortgages are the cheapest form of borrowing available. (Car loans are a tricky exception—more on that in a minute.) So you shouldn’t discount the opportunity to time shift for 30 years at a low cost. Plus, thanks to the home mortgage interest tax deduction, families in the 25-percent tax bracket can potentially recoup a quarter of their mortgage at tax time (assuming they’re early in their repayment years, when much of the monthly payment goes toward interest).

At the same time, there are plenty of ways mortgage debt can turn bad, like getting a subprime interest rate, buying a home that drops in market value and taking on an unaffordable monthly payment—so it’s important to do your homework and know what you’re getting into before taking the plunge.

Note, however, that if you’re the type to giggle at friends who must pay for household repairs while you just call the landlord (hope you’ve got a good one!), consider this: Rents around America are soaring, which means the old-fashioned reason to buy—fixed payments for 30 years—is very much in play.

June 22, 2016

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