good debt v bad debt – is there such a thing?

Posted on April 13 · Comments

Many personal finance writers like to make the distinction between ‘good debt’ and ‘bad debt’. ‘Good’ debt may sound like wishful thinking to many (after all, a true frugal person would consider all debt to be bad, right?) but understanding the difference between the so called good and bad types of debt can affect your financial decision and long term relative wealth.

What is good debt?

‘Good debt’ usually refers to debt incurred to in order to make investment purchases. Using debt to purchase appreciating or income generating assets is usually referred to as leveraging. For example, a mortgage on an investment property that either brings in cash flow or is expected to increase in value is considered good debt.

What is bad debt?

On the other hand, ‘bad debt’ refers to debt incurred purchasing consumer items such as fashion or tech gadgets that depreciate in value. Purchasing such items results in no financial gain, instead they drain your future income due to future repayments and interest expense (and fees).

Is there a grey area?

Is classifying debt as ‘good’ or ‘bad’ as straight forward as that? There are a few grey areas to consider:

Is the mortgage on the family home good or bad debt? On one hand, few would be able to purchase a home without a mortgage, so debt could be considered a necessary tool for home ownership. And besides, one can generally expect the family home to appreciate in value, therefore we can class the mortgage on the family home as good debt.

On the other hand, the family home does not generate an income and the appreciation in value cannot be realised without selling the home or accessing the equity (which is just a nice way of saying borrowing against the value of your home that you have already paid off – not so nice if your home value decreases as we’ve seen in recent years.) Further (in Australia at least) interest on the family home is not tax deductible as it is on an investment property loan. Therefore, maybe it’s better to say the family mortgage is bad debt.

What is your opinion of margin loans (money borrowed to invest in the share market)? Good or bad debt? Those who went bankrupt after the recent share market crash would not consider margin loans good debt, but technically a margin loan is used to purchase potentially income producing and appreciating assets (and the margin loan is also tax deductible.)

What if your appreciating asset doesn’t appreciate? Good debt turned bad?

On the other hand, can bad debts ever be considered good? Consider the family car. If a car is considered a necessary commodity, then necessary debt used to purchase might not be considered ‘bad’.

Another gray area is using short term debt to leverage cash flow. An example of this would be to put all income into a high interest savings account, use your credit card to pay all monthly expenses and then paying off your card before due without incurring interest, using ‘bad’ debt to maximise the interest earnings on your savings account.

How knowing the difference affects your finances

This may all sound like splitting hairs, but knowing the difference between so called ‘good’ debt and ‘bad’ (and the grey areas in between) will help you to make beneficial financial decisions by:

helping you to use debt wisely to generate wealth
understanding that you can use debt to minimise tax
understanding that it is often better to save money and pay cash for consumer and depreciating goods (or to save the biggest deposit possible)
focusing on paying down any ‘bad’ debt as quickly as possible reducing the amount of interest incurred saving money and reducing the drain on future income
Choosing to pay down ‘bad’ debt first over paying down ‘good’ debt

What do you think? Good debt v bad – is there such a thing?