How to Know Good Debt vs. Bad Debt

Is debt good or bad? Is there such thing as good debt? These are difficult questions because, as with most personal finance issues, the answer is as individual as you are. For the most part, debt is bad. Sometimes debt can be good (such as a way to build credit). But debt adds risk to your life — and can take away choices.

However, there are a few basic rules to determining whether debt is good or bad. Ask yourself: Does it provide positive financial leverage? Does the debt have favorable enough terms (rate, payment, length of loan) that the amount of money you will make or save because of it far outweighs the risks and costs involved?

good debt
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Take, for example, student loans. If you borrow $50,000 to graduate from a top-tier school with an expected starting salary of $60,000 in your field, then that’s good debt. Why? If you work at $10 an hour for the next few years to save enough cash to pay for college without loans, then graduate with that same job, you missed a few years of making $60,000 a year. So you’re better off having borrowed the money.

On the other hand, if you borrow $100,000 to graduate from a mid-level college with an expected starting salary of $35,000 — well, that’s bad debt. It will be next to impossible to pay off those loans.

Similarly, debt restricts your life choices.

If you borrow $150,000 to become a lawyer and then decide to work at a legal clinic with a salary of $50,000, you can’t (financially). You don’t get to make that choice because you already used up that choice when you chose to borrow that much money.

Let’s say you hate where you live or you find a great opportunity to move somewhere else and take your dream job. But let’s also say you owe $350,000 on your home and it’s worth only $300,000 because of a weak housing market. You can’t move! You already made your choice when you borrowed that much money.

The list goes on and on. The $200 monthly furniture payment along with the $400 monthly car payment and the $75 credit card payment, and so on, all add up to “you don’t have any money left to do the things you actually want to do.” Your budget may be so tight you can’t even afford to drink your favorite coffee.

So what can you do? You can prioritize paying off or reducing your debt. By paying down your debt you will improve your credit score, have more money leftover to make other important life choices — and you can actually breathe a sigh of relief.

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