Before the Great Recession of 2008 overturned many long-held financial beliefs, it wasn’t uncommon for people to differentiate between “good debt” and “bad debt.” The thinking was that certain kinds of debt were worth taking on because you come out ahead in the long run. Buying a home and financing a college education were two notable examples.
But when home values plummeted and the cost of a bachelor’s degree soared into five or six digits, those once-safe investments in your future suddenly seemed risky or unattainable.
Now’s a good time to step back and examine the concept of good debt vs. bad debt and why, in certain cases, acquiring debt may still make sense — provided you plan carefully and don’t exceed what you can reasonably expect to repay.
This simple distinction still applies: Taking on so-called good debt can help boost your credit rating or allow you to buy something that will increase in value over time, whereas bad debt often fuels the purchase of items that are disposable, unnecessary or rapidly depreciable.
One of the best ways to build strong credit history is to show lenders you can pay off debt responsibly. You’re more apt to qualify for a mortgage, car loan, or other large debt if you’ve demonstrated sound repayment behavior. Just remember: Carrying multiple loans or high-limit credit cards could harm your rating, since lenders might worry you’re taking on more debt than you can repay.
Student loans. The average college graduate earns $47,422 a year, compared to $26,349 for high school graduates — a difference of $21,073. Using simple math, some calculate the difference in total earnings over a 40-year work life as more than $800,000.
However, such estimates don’t factor in the crippling student loan debt many graduates face or their inability to find work in a chosen field during difficult times. But still, the unemployment rate among college grads is roughly half that of high school grads — 4.5 percent vs. 8.4 percent. College is still a worthwhile investment for many people if they don’t go overboard on loans and choose a degree with good earnings and employment potential.
Mortgages. Before the real estate crash, homeownership was considered good debt because historically, when someone finally paid off their mortgage, their home was usually worth much more than the purchase price. For many, this probably still will be true, unless they bought during the market upswing or are forced to sell before prices can recover. After all, mortgage interest rates are historically low and interest and mortgage points are still tax-deductible.
Just don’t buy more house than you can afford. Factor in expenses like property tax, primary mortgage insurance, homeowners dues, utilities and repairs — and if you get an adjustable rate mortgage, calculate how high rates could climb.
Bad debt. What qualifies as bad debt hasn’t changed since the recession, but budget-conscious consumers are paying more attention now. Meals out, excessive vacations, and unnecessary clothing or electronics — wants vs. needs — all qualify if you’re spending beyond your means. Basically, if you can’t pay the bill in full within a month or two, reexamine whether it’s a worthwhile expense; particularly if you don’t have at least six to nine month’s pay stashed in an emergency fund or you’re trying to save for a car or home.
Jason Alderman directs Visa’s financial education programs. Follow him on Twitter at PracticalMoney.