The following is an excerpt from my book Margin Matters: How to Live on a Simple Budget & Crush Debt Forever.
Is there such a thing as good debt and bad debt? Opinions differ, but generally, most forms of good debt are defined as an investment in yourself—such as a school or business loan. Of course, assets that appreciates in value, like a house (in most cases), are considered good debt. Obviously, possessions that decreases in value are bad debt. Unfortunately, that describes many of life’s basic necessities like clothes, automobiles, and that 80-inch, 4K, curved-screen TV needed to host your Super Bowl party. Some common examples include:
Good Debt:
- Mortgage – For most of us, there is probably no better debt than a mortgage (with the exception of purchasing one during the Great Recession and real estate market crash in 2008-12). Likely the biggest financial decision you’ll make, a mortgage is the path to homeownership. Housing prices increased an average of 6.4% a year from 1968 to 2004, and since the Great Recession ended (2012), have returned to a 6.8% increase per year.
- Home Equity Loan or Line of Credit – These are basically offshoots of a mortgage. You get a low-interest loan using your house as collateral. Many people use these to pay off higher-interest debts like credit cards. Some use them to make home improvements to help increase the value of their home.
- Small Business Loan – If you are truly passionate about generating wealth, your chances are much better if you start your own company and work for yourself. Small business loans are tougher to get because they are riskier to the lender. Nearly one-third of small businesses fail to survive their first two years, according to the Small Business Administration. If you have enough ambition, savvy, and luck, borrowing money to start your own business could be the best investment you’ll ever make.
- Student Loans – Regarded as an investment in your future, student loans tend to have lower interest rates, especially if they’re federal student loans. The idea is that you’re buying an education that will lead to a well-paying career. However, you must consider your path wisely in order to achieve success. Degrees in the STEM fields (science, technology, engineering, and mathematics) have higher earning potential. Conversely, you might never pay off your student loan if you major in liberal arts.
Bad Debt:
- Car Loans – For most of us, a car is a necessity. Try to keep total auto costs, including your car loan payment, within 20% of your take-home pay. Shoot for loan terms of four years or fewer, preferably with a 20% down payment. Be smart and avoid splurging on a BMW when a nice Honda will get you there just as well.
- Personal Loans – Incurring debt for expenses like a vacation or new clothes is probably not a wise choice. However, personal loans can be a good option for consolidating debt.
- Payday Loans – These are short-term, small-amount loans meant to be repaid with your next paycheck—and should be avoided at all costs (pun intended). This is what I call toxic debt because it often comes with insane interest rates as high as 300%. Financial experts strongly caution against these types of loans.
- Credit Cards (especially with high interest) – If you’re not making progress on your credit card debt, despite paying all you can monthly, you have a problem. Many credit cards carry extremely high interest rates of over 20%, digging you into an even deeper hole.
How Much is Too Much?
Have you ever been asked, “What is your debt-to-income ratio?” Were you like me, and answered, “Huh?” Figuring this out is not as complex as it seems—no math degrees required. Simply add up your monthly debt payments and divide them by your monthly gross income. For instance, if you have a $1,500 monthly mortgage, $200 car payment, and pay $300 a month for credit cards, your monthly debt is $2,000. (Be careful not to confuse this with expenses.) If your gross monthly income is $4,000, it means your debt-to-income ratio is 50%. It also means you should be losing sleep because a more than a 43% debt-to-income ratio is a red flag to potential lenders. Evidence suggests that borrowers with a higher ratio are more likely to have trouble making monthly payments—meaning you typically can’t get a mortgage if your ratio is over 43%.
Final Thoughts
I hate all debt and it’s my life’s goal to one day live completely debt free. However, I do understand that most of us will have to take out loans for some of life’s bigger purchases such as a house, car, and perhaps to pay for schooling or medical bills. Carrying debt limits our options and creates undo stress and anxiety. Many feel that acquiring a low-interest loan that helps increase your income or net worth is an example of good debt. Consequently, too much of any debt can become bad debt. All debts are not created equal. Sometimes, bad debt starts out as good debt. Do your due diligence to weigh the risks/rewards of your decisions.