Good debt vs bad debt

Debt is a hotly debated topic in the personal finance world. On the one hand, some advocate for NO Debt. They say there’s no point in paying interest and that you’re only opening yourself up to liabilities down the road. They advocate saving up and then paying for things in cash. On the opposite end of the spectrum, we have those that encourage people to take on debt. Citing super low interest rates, they say you’d be foolish not to take on debt. Use the money elsewhere, they encourage. Being a young professional, it’s tough to know what level of debt we should take on. We see some friends with several hundred thousand of student loan debt and they seem ok. We also see other friends run out and buy brand new cars, and they definitely seem to be doing ok. Then you have other friends that stay away from debt, have cut up their credit cards and pay cash for everything. What’s the appropriate debt level for us?

Before we get into it, let’s do a quick history/finance/political lesson on debt. Up until the very recent modern era, debt wasn’t a real concept for many people. If you didn’t have the money to buy something, you couldn’t buy it until you did. Think back to the Wild West (or the Oregon Trail video game) and there were some primitive forms of credit/debit. Shopkeepers would let regular customers open a tab and would let them pay it off each month. This however was more so for convenience instead of not having the money. It could be cumbersome to carry the small amount of money for each trip. Think even further back to colonial times, and they’d put you in jail for unpaid debt. The colony here in the US of Georgia was founded to be a haven for such debtors. Only in today’s modern world is credit readily available and you can’t get thrown in jail for it. Let’s also talk about interest. Interest, the small (or sometimes large) number followed by a percentage sign can make your life terrible. The bigger the number, the more you’ll owe. There’s also a magical function called compound interest which means if you start with owing $100 and then get $15 interest tacked on, you’ll now owe $115 and the interest next month will be 15% * $115, instead of your original $100. Debt can really get out of hand if you’re not careful. Finally, a brief mention on political issues relating to debt. The government has decided that certain types of debts are good for society and will let you deduct the interest you pay off your taxes. Woo-hoo! Notable examples are student loans and your house payment.

With this in mind, let’s now discuss what I consider to be good debt, and therefore encourage allow you to take and then what I find to be bad debt and absolutely recommend you stay away. Overall, debt can be a good tool, if properly managed.

Good debtDSC01139

There are a couple types of debt that are virtually impossible for the average person to avoid and therefore are considered normal debts to have. These are student loans and mortgage payments. College and buying a house are expensive. You could work and save years to go to college but by then you’d be 40. Or, you could make an informed decision, take on some debt, graduate from college and then land a job that pays you plenty that will allow you to pay off your debt. In today’s modern age, it’s pretty tough to not go to college. Jobs are tough enough to find already, much less without a degree of some sort. Don’t automatically jump and accept student loan money from the first place that will give it to you though. There are TONS of financial aid and scholarships out there, for all sorts of students. One regret I have is blowing off this research. I know friends that spent their entire summer applying and writing essays for scholarships. They ended up with thousands of dollars of free money that they didn’t have to pay back. Also, there’s a big difference in the types of student loans. The main two types are government subsidized and not. The government subsidized type loan carries a much lower interest rate, right now around 6% or so. The non-subsidized loans are issued by private lenders and they can charge as high of interest as they like, often in the double digits. Going back to our finance lesson on interest, one of these types of loans will be much better for you in the long run.house-green

Buying a house will likely be the biggest purchase of your lifetime. Depending on where you are a house will likely cost anywhere from $50K to $500K. It would literally take you years to save enough to buy one. This just isn’t realistic for most people, and buying a house using credit is the most viable option. You’ll likely select either a 15 or 30 year loan and take your sweet time in paying it off. When you go to sell your house, you’ll use whatever money you get from the sale to pay the remainder of your mortgage off. The nice thing about buying a house on credit is that here in the US, the US government has made home ownership a priority for the average American and as such, gives generous tax incentives to do so. The interest you pay on your mortgage is tax deductible!

The main reason why these two types of debt can be considered “good debt” is that that they aren’t so much debt, but an investment in your future. Going to college will hopefully give you a good education and a good job, which will set you up for financial success later on. Buying a house allows you to build equity in a large investment (a house), in a tax friendly manner. As long as you’re smart with taking on this type of debt, it can certainly prove to be a good idea for you!

Bad debt

Going back to our lesson on compound interest, debt can certainly get out of control if you let it. One month you’re doing fine, the next you’re treading water and the next you’re drowning. If you’re only making the minimum payments on your debt, they’ll grow more and more each month. To put it bluntly, I consider anything outside of the good debt realm to be bad debt. That means: car loans, credit card debt, banks loans, and basically any other type of debt you may find yourself in. These types of debt involve the mentality of “I gotta have this now”. Instead of being responsible and saving, we put ourselves in a financial mess by agreeing to pay for it later. As much as we’d like to think of ourselves of being capable to “pay this off ASAP”, other things will get in the way of us quickly paying it off.new car

The problem with this debt isn’t even the financial impact it’ll have on you, and how you’ll end up paying much more in interest then you would have if you had just bought it outright. The problem is our inability to say “no, maybe later”. In today’s modern era of getting what we want, when we want, this mentality is turning into a generation of people in debt. Debt seems to be the new normal, something people almost expect to keep with them for the entire lives.

Learn to adopt an attitude of being patient and not putting yourself in a financial situation you know you won’t come out on top of. By saying “no” now, we can say “yes” to a lot more later!

Thanks for reading! Here’s another one you might like: the Freedom from Debt

Also? Looking for a great gift idea this year? How about giving the gift of Amazon Prime? The recipient might even let you use it some too!

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