When you get into debt (or buying something using your credit card), it is very important to identify if the debt incurred is a good debt or a bad debt.
Simply put, a good debt will have a very good potential to increase your cash flow and assets on a future date.
Sometimes the same debt can become a good debt or bad debt, depending on how it is originated and managed.
A student loan is generally considered as a good debt. But if you take a huge student loan and didn’t graduate and didn’t benefit from your education then it is a bad debt.
Taking the minimum amount of student loan that is required to complete a good degree which has a great potential to increase your future income is definitely a good debt. However, taking a huge debt load to obtain a degree which has no demand or value in the employment market will make the student loan a bad debt.
The below table distinctly identifies the typical good and bad debts.
Most often people classify home mortgage and student loans as good debts. But as Money Farmers, we classify them a little bit differently.
|Good debt||In the Middle||Bad debt|
We don’t think anyone will have any argument about the two items listed under the good debts column.
So, what is the meaning of the “In the Middle” column?
The “In the Middle” column is used to categorize all those debt which if managed correctly can fall under the good debt category, but when managed incorrectly will fall under the bad debt category.
A Home Mortgage loan for your primary residence if correctly managed is a good debt under the following conditions:
- The loan is taken with a low interest rate in a rising interest rate environment
- The real-estate price for the home is reasonable based on historic real-estate appreciation pattern for that area. This means you are not buying the home at the top of a real-estate market bubble – remember what happened in 2008?
- There is reasonable expectation that the borrower:
- is able to keep that house for at least 8 years or more to offset the transaction costs
- will be able to make the required monthly payments without default
Under the above circumstances, due to (1) the tax advantage available for the mortgage interest in the current tax code for the primary residence and due to (2) the chance of potential appreciation of the leveraged asset, the home mortgage loan is a good debt.
If any of the above conditions are not met, a money farmer need to think hard before getting into mortgage debt.
A home equity loan and cash out refinance of a home mortgage can be a good debt, if the intend is to utilize the lower interest rate available for home loans to get cheap money to expand a viable business. However they are bad debts, if they are used for consumption (say for vacation, home improvement etc).
A student loan as explained before, is generally a good debt. But if the money was borrowed indiscriminately for the wrong degree program, then it definitely is a bad debt.