In this article we’ll explore the Good, the Not so Good, and the just plain Bad when it comes to different types of debt. I’m a firm believer that there are certain types of debt that are actually good and can help us achieve FI faster, but unfortunately most folks never acquire that kind of debt.
Most of the time when we’re talking about debt, the kind that people struggle with, we’re talking about Bad debt, or at least Not so Good debt. This is the kind of stuff that can really weigh on us, maybe keep us up at night. It’s bad for our mental health as well as our financial health.
This is the type of debt that we definitely want to target for rapid paydown before we even start to focus on saving and investing.
Now, let’s get into some definitions!
Good Debt
We’ll start with the mythical Good Debt bucket. This category holds loans acquired for investment purposes. Examples include loans used to purchase a rental property, to start a business, or to acquire some other income producing asset. Interest rates on these loans are typically low to moderate, and the interest expense itself is often tax deductible. We like that!
People take on these loans because they’ve done the math and determined that they’ll earn a positive return from the loan. The loan will essentially pay itself off over time – and then some!
This is the type of debt you can actually feel good about. It can help accelerate your journey to FI.
Not so Good Debt
These debts are often acquired to cover non-discretionary needs such as shelter, for example a house or condo mortgage, education expenses (student loans), or transportation. These loans generally have lower interest rates than Bad Debt and are often secured against some asset.
Although these debts may be acquired to cover legitimate needs, because they don’t generate a positive return vs. other alternatives, they end up falling into the Not so Good bucket.
Let’s take a look at buying a car for example. If you buy a new car, its value will typically depreciate by about 20% in the first year and then up to 15% per year thereafter, depending on the make and model, according to data from CARFAX. On top of that, you’ll have to deal with insurance, gas, and maintenance expenses.
Now that’s a really poor investment!
Of course, owning a car can be very convenient, and if you live out of town away from public transit services, it could be a must. But be aware, it’s not a good use of our financial assets.
The best we can do in this situation is not overpay for a vehicle. My personal preference is to buy a 2- or 3-year-old Toyota or Honda, take good care out of it, and get the most use out of it that you can.
Wait a minute! How come a house mortgage or student loan isn’t considered Good Debt?
Good question. The answer is that these could be good debt, but they often aren’t.
In the case of a mortgage to purchase a home, we’d need to look at how the cost of home ownership, including all costs of owning and maintaining the home, compares to the cost of renting. Unfortunately, these days, even factoring in some appreciation of the home over time, renting often wins out.
This isn’t the case in all areas, though, so make sure you do the math and don’t overpay.
Similarly, a student loan could be considered Good Debt if the program you’re going into will actually result in you earning more income in your career. This is certainly possible, but we need to do some research beforehand to be certain.
Don’t just assume that investing in education will have a guaranteed positive return.
Bad Debt
In this bucket we’ll include any credit card debt that we revolve from month to month, that is, debt we’re not paying in full each month. Sure, credit cards can be used for discretionary and non-discretionary expenses, like food and clothing, but more often than not it’s the discretionary purchases that get us into trouble.
We’re talking about trips, dinners out, concerts, sports equipment, and events, etc. Basically, the types of purchases that we could live without.
I’m not saying we should never buy these sorts of things. I’m a big believer in the idea that life is meant to be lived and enjoyed, but we need to balance these purchases with our other goals in life. Goals like not being stressed all the time, and having the flexibility to be able to save and invest for the future.
We’ll also include consumer loans and lines of credit in the Bad bucket. These are often used for purchasing larger appliances, furniture, a trip, a boat or ATV, etc.
With the high interest rates generally found on credit card and consumer loans, often higher than the returns we are likely to get through investing, it just makes sense to prioritize paying off these debts before focusing on saving and investing.
Wrapping it up
To wrap it up, Good Debt pays for itself and can help us accelerate our journey to FI.
Not so Good Debt can allow us to cover a legitimate need or desire, but since it carries a negative or uncertain return, we should plan to minimize these debts.
Bad Debt tends to come with high interest rates, and is often acquired while covering wants rather than needs. Our goal should be to minimize these debts and target them for rapid paydown.