The difference between good and bad debt

No one ever wants to be in debt. But, if you are, is there such a thing as "good debt?"

"I definitely think there's good and bad debt," says Sean Cooper, a personal finance journalist who devotes an entire section to the topic in the book he's currently writing, Burn Your Mortgage: A Simple, Powerful Path to Financial Freedom.

"Good debt is when you borrow money for an appreciating asset or something that can increase your income," he says. That would include some sort of investment -- such as a mortgage or a student loan -- that could potentially increase your net worth now or in the future.

On the other hand, bad debt is accumulated when you acquire something that depreciates in value or is something you consume right away, such as charging expensive concert tickets or a vacation you can't really afford to your credit card. good-debt-bad-debt

"It's usually when we borrow money for consumer items and spend money that really doesn't have any value after it's spent," says Rubina Ahmed-Haq, family financial adviser for President's Choice Financial.

Can good debt turn bad?
The difference between good debt and bad debt isn't always so black and white, though, as good debt can turn bad quickly if you're not careful. Without a plan to repay the good debt, it can be just as damaging as charging superfluous items on your credit card. For instance, going into debt to earn a degree is usually considered good debt, but if it lingers too long without being paid off, it can quickly transform into bad debt.

"If you're going to school, the expectation is you're going to have this great salary when you graduate, but that doesn't mean you shouldn't have a plan in place when you're borrowing it," says Ahmed-Haq.  "When you do land that job, you should already know exactly how you're going to pay that good debt off."

Good debt can also turn to bad debt if the good investment stretches you beyond your means or if the debt isn't going toward its intended positive purpose. "If you buy a house that's going to cripple you financially or if you go to school for a degree, but you can't get a job at the end of it, that's when I think good debt can go bad," says Cooper.

When you take on any kind of debt, ask yourself whether you'll still be able to make the payments even if you were to undergo a major lifestyle change, such as having a baby or having to take care of aging parents. For example, when people get a mortgage, Ahmed-Haq recommends they calculate their payments at a rate that's two percentage points higher than what they're getting from the bank.

"This way you know that if interest rates rise at the end of your term, you already know you can afford it," she says.

Should you aim to have a certain amount of good debt?
Many people probably have some combination of good debt and bad debt in their portfolio. "Everyone's financial situation is different," says Cooper, "but if you're taking on any kind of debt, ask yourself whether it's good debt or bad debt and look at what you're using the money for."

Ahmed-Haq says ideally, you should limit bad debt as much as you can, or, of course, avoid it altogether. "Purchasing things that don't have value after you've purchased them should only be done with money that's considered surplus in your budget," she says.

However, she knows some needs are unavoidable, such as needing a new jacket when it's cold or a new refrigerator when yours breaks. You may not always have the money in your budget when those necessary expenses come up, leading you to use your credit card to pay for them. But try not to splurge for wants with money you don't have, to avoid the kind of bad debt that can spiral out of control.

See related: Coming to terms with student loan debt, Ways to overcome the stigma of debt, What's next after a $0 balance?
Published May 13, 2016

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