Do You Have Good Debt or Bad Debt?

There are some types of borrowing that can be very good for you over the long run!

Apr 19, 2014 at 11:00AM

When it comes to debt, less is better, right? Generally yes, but the kind of debt you carry can matter just as much as how much you owe. Some borrowing can actually make you money in the long run, and some is backed by assets that will appreciate in value over time. There is also some debt that will leave you broke, if you let it. Look at your own situation: how much bad debt do you have? If the answer is "a lot," here's why you need to do everything possible to get rid of it.

Great debt can make you money
Even if you can afford to pay cash, it is almost always a good idea to finance your home, especially at today's low interest rates. It is completely reasonable to expect to earn returns of about 7 to 8% on your investments, so if you can borrow money at 4.5% or so, you actually make money by leaving your cash in savings.

For instance, let's say that you have $200,000 available either to invest or to buy a home. If you finance your home purchase at 4.5% interest, then over the course of a 30-year mortgage, you'll end up paying about $365,000 in principal and interest. However, by investing that $200,000 at a 7% annual return, you'll have more than $1.4 million after 30 years of compounding.

$200k invested for 30 years vs. total mortgage payments | Create Infographics.

Additionally, "great" debt is backed by assets that appreciate over time, like a house. So not only will you do better leaving your money in the bank, but when all is said and done, the house will (hopefully) be worth more than you paid for it.

Good debt serves a purpose while not breaking the bank
There are two basic types of good debt: low-interest debt for something you need (like a car), or debt that will enable you to improve your quality of life (like a college education). Both can generally be had for interest rates that are not too much higher than that of a mortgage.

A college education can raise your earning power considerably over your lifetime, and it can more than pay for itself in just a few years. Consider that the average U.S. worker with a high school diploma earns $1.3 million over his or her career, compared with $2.3 million for those with a bachelor's degree and $2.7 million for those with a master's, according to a Georgetown University study (link opens PDF). All of a sudden, borrowing for tuition at 6% to 7% interest doesn't seem like such a bad idea.

Bad debt, when used poorly
While credit cards are a dangerous form of debt when misused, they can be necessary to give you the best credit possible. Credit cards charge very high interest rates, ranging from 12% to 30% or even more, so it doesn't make sense to carry a high balance.

However, when your credit score is calculated, it helps if you're indeed using your revolving credit accounts responsibly. According to myFICO.com, the average "high achiever" -- a consumer with a FICO score above 800 -- carries a balance that is equivalent to 7% of their total credit limit. So if you have a $10,000 line of credit, carrying a balance of about $700 isn't a bad thing and could actually help your credit.

Get rid of bad debt before anything else!
If you have excessive high-interest debt, your absolute first priority should be to get rid of it before buying anything else. Even if you don't have the money to pay off all of your credit cards right away, look into transferring your balances to a new card, as you can usually find promotional 0% interest deals.

Investing and saving make little sense if you're paying 20% interest or more on your debts. Credit card debt of $10,000 will cost you $2,000 per year in interest alone (and 20% is a low estimate), and you would need some pretty awesome returns on your investments to make up for it!

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