Borrowing

What's the Difference Between Good and Bad Debt?

Bob Sullivan

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 7.6 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.

Mortgages

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 can potentially recoup some savings (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.

Car Loans

You’ve probably heard that new cars lose up to 20 percent of their value as soon as you drive them off the lot—which means all car loans are bad, right? Generally, yes.

But while car loans can turn upside-down quickly, you may not want to completely write off this debt because of the very cheap rates available. (For example, a $15,000 loan with 3-percent interest over 48 months costs $937 in interest or about $20 per month.) And cheap money can be advantageous.

I learned this the hard way. After graduating law school, I funneled all my savings into a car purchase to avoid a loan. Two months later, I got the job opportunity of a lifetime—across the country. I had to move, set up an apartment and buy new clothes, and ultimately ended up with thousands of dollars of high-cost credit card debt to cover it. I wiped it out in six months, thanks to my new income, but I also paid quadruple the interest than if I’d kept my cash and took out a car loan.

Of course, the best option is to have enough money saved to cover expenses like this without having to incur any debt. But if you need a car and buying a used one outright will wipe out most of your savings, and you can borrow the money cheaply, it’s worth considering it—especially if you’re earning money on the savings you have left (though you’re not likely to be making as much in a savings account as you’d pay in interest for a loan these days).

Now when I buy a car, I pay half in cash, half with a low-rate loan. That offers manageable payments and liquidity. (And you can always pay the car loan off early.)

Credit Card Debt

Most of the time credit card debt is bad for you, even when it’s cheap. While 0-percent-interest promotions sound great (until they expire and spike to expensive rates), they rarely solve someone’s financial problems because they don’t fix cash flow. Until you change the spending habits or other circumstances that drove up your balance, you’ll always shoulder bad debt.

That’s why I hesitate to call any credit card debt good. So I’m inventing a new term called “not-so-bad debt.”

The foundation of financial security is the emergency fund, which should contain about six months’ worth of living expenses for when unexpected expenses come up—but nearly half of Americans don’t have anything close to that. So realistically, a credit card in good standing with a “not-so-bad” interest rate—like, say, 8 to 10 percent—is the next best thing, as long as you don’t miss a payment and pay it off quickly.

The problem is when you fall into the habit of carrying a balance and become a “revolver.” That means all new charges are subject to immediate interest fees, and it’s easy to lose track of June’s spending versus May’s borrowing and so on. Revolving is deadly to budgeting.

I recommend having two low-interest cards—one is for everyday purchases that you pay off in full (ideally, this one rewards you with points or cash back and has no or low annual fees); the second is a line of credit to only be used if a surprise life event comes up that you can’t cover with cash, like a hot water heater replacement. Then stop using it until you pay it off. This way, you have a tight grasp on how much your “not-so-bad” debt is and when you can free yourself from it.

This story was updated in January 2019.

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