Debt: the good, the bad, and the ugly

You hear it all the time: don’t get into debt, pay it off in full if you can, don’t take out loans. A lot of the time it does make sense to avoid debt, but there are definitely “good” types of debt. So that’s today’s topic - good debt vs. bad debt. Let's dive right in.

Bad Debt

Let’s start with the debt you should always avoid, the grim reaper of debt, which is….CREDIT CARD DEBT 💳. But Matt, you just told me to get a credit card in The 5 minute credit card guide. True, but I also told you to pay it off in full every month! Credit card debt. The average interest rate on a credit card as of 11/20/19 is 17.21% source, with many popular cards in the 25-35% range. This is a complete 🙅🏼‍♀️, since you’d have to earn more than that amount on your money with an investment to make that worth it. Of course, those types of returns are very difficult to achieve (unless you happened to buy bitcoin pre-2016 and sell it at the right time - then by all means run with that card debt). So, long story short - stay away from credit card debt.

Good Debt

Now let’s talk about the bright side of debt ☀️. Think of the purchases that people commonly take out loans for: house and car. Let’s imagine it’s 2014, you have some cash saved up, and want to buy a car that costs $20,000. You find a great offer with a 1.9% APR and 2000 down, bringing your payments to $315 a month and total cost of $20,883 after interest. You take the other $18,000 and invest it in an S&P 500 index fund. In 2019, the value of your $18,000 is now $27,400 source, and your car is paid off with the monthly income from your job. On the other hand, if you had used that money to buy the car in full, you’d have saved $883 on interest, and foregone over $7000 in gains. The potential lost income from not choosing the loan is called the opportunity cost, which will be discussed many times on my blog. This brings me to the main point to remember behind all of this:

If the interest you’ll earn on your money is greater than the the interest you’ll owe borrowing that money, it’s good debt. Otherwise, it’s bad debt.

Now clearly this is an oversimplification and doesn’t account for factors like inflation, volatility in markets and other complexities but it’s a good rule of thumb to start with when considering whether to take out a loan or mortgage.

Caveats

While this holds true in most places, it’s also important to recognize that the more debt you have total the harder it is borrow more money, and the higher the monthly burden you have will be. So even if you can buy 6 houses in West Virginia with 3.5% interest rates on a 30-year fixed rate mortgage, should you? Maybe not.

Personal Finance blog by Matt Gabor
Consumable knowledge bytes to chomp on your path to wealth. All posts are under 500(-ish) words. Trying to help at least one millennial become more financially literate.