Good Debt vs. Bad Debt: Why Knowing the Difference Matters

When I was still a student, I often heard admonitions to stay away from debt. Debt, I was told, was bad. I should avoid it at all cost.

However, I have also seen that people did not really think debt was that bad. Incurring debt was a normal way to acquire things. Most people have debts. Credit card debts, salary loans, and other high-interest debts were not shunned. Installments were very popular.

Furthermore, I have seen businesses use debt as an ordinary method of financing. If debt was always bad, how come all businesses have debt in their balance sheets?

These observations taught me three things:
  • People, oftentimes, don’t know what they’re talking about. I should think for myself. Investigate to know the truth.
  • Debt is sometimes good and sometimes bad. Knowing which is which is important.
  • People with bad financial habits make wrong decisions about taking on debt all the time.
Not all debt is good and not all debt is bad. But what characterizes good debts and bad debts so that we can distinguish one from the other?

What are Good Debts?

Good debts are debts used to purchase something that will increase in value. 

It should be noted that debts have a corresponding fee called interest. The rate of interest is the amount you pay for having the benefit of using borrowed money. To know whether or not a debt is good or bad is to assess if the future benefit as a result of debt is deemed greater than the cost incurred because of interest payments.

For example, a college student is justified to take out student loans because the value it adds to him or her increases his or her potential earnings in the future. The cost of debt is minimal compared to the future gains the student will get.

More generally, debts are considered good when they are used for investments. Business loans are used to make better products which results to more earnings for the enterprise. Investments financed with debt can have future gains that are comparably much greater than the expense paid because of getting into debt.

With the above context in mind, it’s easier to delineate bad debts. 

What are Bad Debts?

Bad debts have two characteristics:
  1. High interest rates
  2. No long-term benefit
When you have debts with abnormally high interest rates, you should know they're bad debts. Pay them off as soon as possible. 

High interest rates could mean that the debts were unsecured such as credit cards, and uncollateralized salary loans. The interest rates are reflections of the risk the lending institutions take on with these debts. The higher the risk the higher the interest rates charged.

Two of the most common high interest debts you should totally avoid are credit cards debts and salary loans. Their astronomical rates will suck your resources faster than you think. It will get you deeper and deeper into debt until it’s very difficult to get out. Unless you have the discipline to pay your monthly credit card balance in full before due date, you shouldn’t have credit cards at all.

Bad debts are incurred to purchase things that quickly lose their value and do not generate long-term income. Examples of these are spent on food, clothing, vacation, etc. A need or a want can both be in this category. As long as they have no future value, acquiring them by getting into debt is a very bad idea.

So with all these, how do we make sure our financial life does not get off-track? If it is already off-track, how do we make it better?

Here are a few tips you may apply which we will talk more about on the next few posts.
  • Pay off your bad debt first
  • Use cash to pay debts, not more debt
  • Don’t take on too much debt (good or bad)