Good Debt, Bad Debt, and How to Tell the Difference
By: Janet Herrick CFP
In my experience, a person who hasn't gone into debt at some time is very rare, but I do recall coming across such a person long ago when I was in my late teens. This particular gentleman happened to own a beautiful little resort that I was staying at. As he showed me around the property, I vividly remember him proudly stating that everything he owned was bought and paid for in cash. "Never a borrower nor lender be," he advised me adamantly. "Sometimes you might have to go without, but everything you own should be paid for upfront."
I was a little skeptical of what this gentleman told me though very impressed with what he had accomplished. It takes money to make money I had also been told. If you didn't already have money then the next best thing was to borrow some and put it to work to make some more. "Don't you think it might be a good idea to mortgage the resort and put in the par three golf course that's next on your list of improvements now?" I asked. "No," he said. "I've seen what debt can do to people."
He was right in that debt does do things to people. Time spent as a bank-lending officer taught me that mismanaged debt could cause all sorts of problems. Over the years I've come to learn that there are two kinds of debt, bad debt and good debt. To put it simply, good debt is for a purchase that will increase in value or create an income in excess of the cost of borrowing. Bad debt is borrowing to purchase something that will fall in value or provide little to no return. Good debt pays off by increasing wealth while bad debt carries the cost of reducing wealth.
Good Debt
Mortgage - Property should appreciate over time and fulfills a need for shelter. If purchased as an investment, it can provide income and eventually capital gains when it is sold.
Investments - Stocks, bonds and mutual funds provide opportunities for income and growth. Investment income such as capital gains or dividends has certain tax advantages. (The interest cost of borrowing may also be tax deductible depending on the type of investment return expected.)
Education - In general, the person with a trade ticket, a college diploma or university degree will wind up with a higher paying job and more career choices.
Vehicle - If the vehicle is necessary, an economical vehicle is purchased to suit the need. If the vehicle will be around long after the loan has been paid, this may be considered good debt.
Bad Debt
Vacation - A vacation is an event that should be planned and saved for in advance as part of budgeting the household income.
Credit card debt - Most purchases charged on credit cards are for consumer items such as clothing, restaurant meals, and even groceries. These items should be paid for in cash.
Vehicle - If the loan will exceed the life of the vehicle or the vehicle chosen is extravagant in relation to need, this would be considered bad debt.
Did you notice that a vehicle purchase could be good or bad?
What is the best way to get rid of or avoid bad debt? Can bad debt be converted to good debt? Should a person think about borrowing to increase wealth?
As every individual's situation is different, I recommend the services of a professional to find appropriate answers to the above questions. A Certified Financial Planner professional has the education and expertise to provide objective advice and well thought out recommendations.
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