What’s the Difference Between “Good” and “Bad” Debt?

The fallout of the Great Recession proved all too well that debt can turn ugly. In response, many have opted to avoid it altogether. Millennials whose debt strategy centered on avoidance are finding that strategy also has its ugly sides. So if debt can turn ugly, but not using debt also is bad, what’s a person to do? How is a consumer to differentiate between debt that helps and debt that hurts?

Why is some debt bad?

Wide-spread ugly debt was one of the causal factors of the Great Recession. Bad debt is difficult to repay and tends to trap people in a never-ending cycle of chasing their own tails. A great example of “ugly” debt are the so-called payday loans that have prompted a government crackdown.

If it sounds too good to be true, it probably is

Traditionally, mortgages are usually considered good and necessary forms of debt. However, in the years just prior to the Great Recession, many mortgages were written with “teaser” introductory interest rates that later automatically switched to adjustable interest rates comparable to many credit cards. Having a credit card with a 12% interest rate might not be great, but it’s manageable with proper care. That kind of interest on a home mortgage is, frankly, predatory. In some cases people’s mortgage payments doubled overnight.

Ugly debt can often be avoided by being careful before accepting debt that sounds too good to be true. If you have a subprime credit score, you should expect to pay subprime rates. If someone offers you a credit card, car loan, or home mortgage when traditional sources have turned you down, ask for details. Legitimate lenders will be happy to explain the details of what they’re offering and what you need to do to remain in good standing. Predatory lenders offering ugly debt, by contrast, will work hard to obfuscate the details in an effort to get your signature on the dotted line.

How can you identify bad debt?

What exactly constitutes “bad debt” can be subjective. Some people – like Warren Buffett – think all debt is bad. If you’re a well-known billionaire living in Nebraska, you can get away with such an opinion. For the rest of us, some debt will be a fact of life. For our purposes, let’s equate bad debt with a sugar cookie (or a donut, or a chocolate bar, or whatever treat satisfies your particular “yum” craving).

There are some people who live most of their lives without eating a cookie – generally there’s a very high concentration of such people in Olympic training camps. They have chosen a high bar for themselves, and that’s OK. There’s nothing inherently wrong with not eating the occasional cookie. Generally people only get into trouble when they are in the habit of consuming a dozen or so at a time.

Like the occasional cookie’s contribution to your physical health, bad debt does nothing positive for your financial health – in fact, it tends to detract from it. But like that cookie, occasional and responsible consumption won’t carry any serious long-term risks.

The same thing happens when you load up your credit card and don’t pay it off in full at the end of the month – you convert net wealth into thin air. Think about that the next time you consider pulling out your plastic to purchase beer and pizza for your roommates.

When debt is good

Good debt is like a well-trained dog: you may need to feed it, but it does what you want it to do. In some cases, debt can help increase your wealth.

How can debt, interest rates, and payments increase my wealth? It sounds counter-intuitive, but this is exactly the way large corporations manage their multi-million dollar portfolios: they add debt-financing to their overall capital management strategy. The concept is simple: invest your capital at higher rates of return, and borrow someone else’s money at lower rates of interest.

Here’s a simplified example: Suppose you have a 750 credit score and you purchase a house for $200,000 over 30 years with 5% down. Your interest rate will be around 3.74%, making your monthly mortgage payment approximately $879. Assuming you stay in your house for the average tenure of nine years and realize the national benchmark annualized appreciation of 5.1%, you should be able to clear a cool $14,700 when you sell your house – even after paying for your realtor’s commission, your closing costs, your buyer’s financing fees, and your own home mortgage interest! In this case the mortgage was good debt – it allowed for the use of other people’s money to increase your wealth.

What’s more, using the bank’s money to finance your home allows you to use your earned income to invest in the S&P 500, with an average return of 9.64% over the last 30 years. Because you don’t need to tie up $200,000 of your income to buy a house (because you get to borrow the purchase price), you have the resources to invest and possibly increase your wealth if you so choose. Good debt not only helps you build wealth, it also allows you to “double-dip” the benefits.

When debt is wonderful

Not only does it make sense to use other’s money to build your wealth whenever possible, but responsible credit usage actually helps you in many other ways.

Responsible credit use builds a good credit score, which is frequently used as an impartial third party gauge of an individual’s financial responsibility. Your credit score will be checked before you can secure a car loan or mortgage, factoring into the interest rate you’ll pay. It will be checked when you try to rent an apartment and when you call to get the utilities in your name. Potential employers may check your credit before offering you a job for which you are otherwise well-qualified. An insurance company may check your score before determining how much they’ll cover and what your rates will be. Credit scores matter in virtually every attempt you make to build a secure future.

Good debt helps you build wealth

Debt most certainly can be ugly, and debt can be bad when it destroys wealth. Good debt, on the other hand, helps you build wealth.

A basic premise in obtaining good debt is that you have access to the best possible interest rates, requiring an excellent credit score. Opportunities to establish and build your score without paying high interest rates can be hard to find. Finding such an opportunity with a supportive lender is truly a unique find. That’s the very reason Grow Credit was founded – to help our customers establish credit and build their credit score.