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Reader-Submitted Question of the Day – Day 6
By JLP | May 6, 2008
Here’s today’s Question of the Day sent in by Bozo:
What is Good Debt and What is Bad Debt?
Most folks have debt. Many folks can’t distinguish between “good debt” and “bad debt”. Can you? What do you define as “good debt”? “Bad debt”? Many FICO scores are based on DTI, or Debt-to-Income ratios. DTI generally doesn’t include debt to own a home, even if the loan was sub-prime. Is this a mistake? Are FICO scores even trustworthy?
Guess that’s more than one question for the day.
Yours,
Bozo
This is a good question. Although some bloggers don’t distinguish between good debt and bad debt, I do. I like to think of “good debt” as debt that is used to purchase an asset that will increase in value (like a house under normal circumstances). “Bad debt” is debt used to purchase depreciating assets (like a car or TV) or consumption (like charging a dinner).
It’s important to note that just because something is considered “good debt” does not mean that you should spend more than you can afford.
I’ll have to do a follow-up on the second part of the question regarding DTI and FICO scores as I don’t know the answer to that one off the top of my head. Stay tuned…
Now it’s time for AFM readers to weigh in. Do you distinguish between good debt and bad debt? If so, how? If not, why not?
Topics: Question of the Day | 16 Comments »
May 6th, 2008 at 10:32 am
good debt is debt you can afford.
good debt as it pertains to the question, though, is debt that is collateralized/secured/assetized (choose your non-word flavor). student loans aren’t really secure in that they don’t have something directly tangible, but the feeling is that the loan is an investment that will yield to a job, therefore good debt. good debt is termed (i.e. has x time of payment), whereas bad debt is open ended like credit cards.
May 6th, 2008 at 11:07 am
Good Debt:
Housing including equity loans (as long as they will increase the value and your enjoyment and you can afford to make the payments)
Educational Loans (as long as they are federal)
Bad Debt:
Everything else
May 6th, 2008 at 11:07 am
I agree with JLP’s definition of “good debt” – good debt is generally debt that can increase your net worth.
Typically, a traditional mortgage (with 20% down) is considered “good debt.” I would also include most student loan debt in the category of “good debt” if you are acquiring the debt so that you can enter an industry where you are 99% certain that your earnings will increase substantially. For example, an MBA or JD will likely be a good investment – as long as you don’t plan to do a lot of non-profit or pro-bono work. I would think twice before financing a master’s in social work at a prestigious university entirely with student loans.
As far as DTI and FICO – FICO looks at your total available credit to credit utilized (the aggregate balance and percentage advanced on all of your revolving lines including HELOCs, credit cards, and overdraft protection lines – if they are reported). By closing credit cards that you do not use, you are lower to debt-to-available ratio, which lowers your FICO score (it’s screwy, but that’s how it works). Financial institutions use DTI along with FICO to determine credit worthiness and interest rate.
Rolling credit card debt is typically bad debt, but credit cards are not innately evil. Using a credit card periodically can really help raise your FICO score. I encourage people with no credit to use a credit card once or twice a month for a low-dollar, routine purchase – such as gas – and then pay the balance in full every month in order to establish a good credit history.
May 6th, 2008 at 11:12 am
I don’t think you’re correct that your FICO is calculated using debt to income since the credit bureaus don’t know your income, only what is reported by your creditors. It is the ratio of your debt to available credit that is factored into your credit score. At least that’s how I understand it.
May 6th, 2008 at 11:27 am
I agree with JLP, but I don’t think of it in terms of using debt for an “investment”, but more or less financial leverage.
For example, if you want to buy a house and save up enough money to pay in cash, how long would that take you? For most people, a few decades. And in doing so, you’re taking money away from other areas of your financial situation (retirement, emergency savings, college savings, etc). So, if by using the debt as leverage so that you can get something now, while still being able to fund your other goals, that is a good debt to take on.
The same thing can apply to student loans, and even auto loans. While they may not be technically investments, if the debt you take on allows you to obtain something you NEED without forcing you to wait for a long period of time, or sacrifice money that needs to be used for something else, then it is generally a good debt.
But even good debts can quickly turn bad, as it has already been briefly touched on. You can take a traditionally good debt like a mortgage, but buy more home than you really need, and with no money down, and find out that it turns out to be bad. Or you can overextend yourself and buy a $50,000 new car when you really could get by fine by picking up a used car for half the price. Or you could decide to get a worthless college degree, or obtain a masters when you don’t really need it, and find yourself needlessly in student loan debt.
And with the complete opposite mindset, you can take what is traditionally considered bad debt, and use it wisely and to your advantage. No form of debt is inherently bad, and no debt is inherently good. It is all about why, and how you use it.
May 6th, 2008 at 11:41 am
I don’t agree with this distinction. If it’s ok to purchase (theoretically) appreciating assets with debt, why is it that the only asset we buy is a house? Why not leverage to buy equities or bonds?
In fact those have even higher expected return, so it seems like an either better idea. Ok, so homes have a useful function as well, you say. But you can rent a house and invest the difference leveraged in equities. I suspect that will have much higher returns than buying a house. Why does no one do it?
May 6th, 2008 at 11:57 am
I’m of the opinion that all debt is bad debt, although I do think that what you and others would call “good debt” is less bad than other kinds of debt. That said, I think you make an important distinction that isn’t made in mainstream culture: just because something is considered “good debt” does not mean that you should spend more than you can afford.
Two prime examples of this are student loans and mortgages. Our culture constantly inundates us with the message that both of these debts are “good debts” without ever qualifying that you should still limit your consumption of them to a reasonable amount. Consequently, people get way in over their heads buying homes they can’t afford and taking out insane amounts of student loans.
Now, I’m all about personal responsibility, so I’m not suggesting that borrowers (myself included) aren’t to blame for their own mistakes. But I do think that part of the problem stems from the fact that our culture calls these things “good debt”. When something is good, you should have it, and you should have a lot of it. This isn’t the case with debt of any kind, good or bad, which is why I wish people would stop calling it “good debt”. Calling it “less bad” or “tolerable” might make people think twice about jumping in without checking the water level.
May 6th, 2008 at 12:03 pm
I think that the financial community did itself a diservice by distinguishing “good” debt as being for an asset that appreciates (mortgage, education, etc.). In the rush to simplify, the public lost track of what debt can do to them (housing bubble and students with $100,000 student loans with $10 hour jobs).
The house or education is an investment. In deciding whether to invest or not, you need to see if it is worth it. A $100,000 education for $10 hour job may not be worth it. A 1/2 million home that goes for $100,000 in the midwest may not be a good investment unless you expect to sell 1/3 acre vacant lot for more than $400,000.
Then the debt part comes in as to how much and at what rate you need to pay it back at. A variable loan where payments can got up to 2/3rd of your income is not a good loan. Many people forget to do this analysis because they are fixated that mortgage and education is a “good” debt. A mortgage and education may be a good investment … yet the terms of the loan determine if it is a good debt.
May 6th, 2008 at 12:28 pm
Andy, tons of people leverage to buy stocks, bonds, options, etc. The problem is that you don’t hear about it because most people simply don’t have the time, ability, or resources to take part.
And if you’re talking about leveraging money to buy stocks, where do you get that money from? Unsecured debt to put into the stock market will come at a price that is probably as high, or at a higher interest rate than your expected long-term rate of return on your investment.
If you use collateralized debt to fund your investment purchase, then you need some sort of asset to back the purchase. For most people, this would mean tapping into home equity. For others, it means having an investment account that gives you margin. And again, the margin extended to you is based on the value of the securities and cash in the account. You can’t simply deposit $1,000 into your brokerage account and expect your broker to give you $50,000 of margin to play with.
So that is why more people don’t do it. You either have to borrow money at a high rate that makes it unattractive, or you have to have fairly substantial assets to begin with in order to take advantage of the attractive rates on the money.
Sure, you can rent and invest the difference, but this isn’t a case of taking on debt in order to fund a purchase. It is just living in a place that is even more affordable, which allows you to put more money towards other things, such as stocks.
May 6th, 2008 at 12:41 pm
I definitely think student loans are a “good debt” – they’re an investment in your future earning potential!
May 6th, 2008 at 1:40 pm
I heartily agree that the key is to get only what you can afford. We have a modest house in a decent neighborhood and a manageable amount of student loan debt. Happily, the student loan debt will soon be paid off. We could have borrowed more for both, but we decided that it would be turning “good” debt into “bad” debt.
May 6th, 2008 at 1:45 pm
I can’t think of anything I’d call “good debt”. Having to get in debt is not good. On the other hand, charging every possible purchase to a credit card and paying the balance in full a few days before it is due, is a good thing. To me, to pay interest is to be exploited.
May 6th, 2008 at 2:26 pm
I just wrote a post about this earlier this week called “No Bad Debt, Only Bad Borrowers.” I think any debt can be good debt if you are using is properly to increase your income and/or net worth (even credit card debt).
By the same token, even “good debt” like student loans and mortgages can actually be BAD if the borrower is irresponsible or uneducated about how to use debt.
Any debt is bad if the payments are so great it’s actually holding you back instead of enabling you, if you’re getting poorer instead of richer each month/year, and if you don’t have adequate reserves or income streams to make the payments in an emergency.
May 6th, 2008 at 2:33 pm
Good debt is when the money can be used for productive purposes – actively working to create value over and above the funds due to the lender. A good example would be education – students have earning power over and above the value of the outstanding loan. This is especially true since interest rates are so low on student loans. It’s hard to imagine subprime individuals creating value from added debt.
Despite what people think, real estate prices do not always increase in value. Describing good debt as that used to buy a house is the mentality that led to our current economic uncertainty. Just buying a house and living in it doesn’t directly create value.
May 6th, 2008 at 3:58 pm
“The borrower is slave to the lender.” I hate debt. There is no such thing, in my book, as good debt.
May 7th, 2008 at 7:44 am
Well, a mortgage is subsidized to some extent by the rent you no longer pay. That is something.
A fixed interest rate is important in my opinion. You are then consequently subsidized by inflation as well, since the dollars later on are worth less than the dollars today.
I might characterize good debt as debt that increases your security. You can be somewhat insulated from cost increases when you buy a house, since your payment doesn’t change over time while your rent would. Like everything else, it isn’t a perfect rule.