Thursday, June 29, 2006

Is there "good" debt?

Kate of the personal finance blog Kate Spills the Beans questioned in her June 4th post if there is such a thing as “good” debt. Yes, Kate, there is such a thing, and the msn Money article you refer to actually does a good job of clarifying the difference between good debt and bad debt.

Here’s my quick take on the subject. First, what’s bad debt?

New car loan=very bad debt. As they say, a new car decreases in value the second you drive it off the dealer’s lot. Interest from a loan piles on to an already inflated sticker price. So you are paying even more to buy something that will be worth dramatically less over time. Two tips: First, buy a “slightly used” car with 10,000 to 20,000 miles on It. Second, start saving for it now so you can pay cash.

Plasma TV by store credit, 0% interest=bad debt (with a catch). You can avoid the interest that would increase the TV’s true price by paying off the debt within a year, which can be good. But you are committing yourself to those monthly payments, which can be bad. What if you lose your job? What if your car dies and you have to get a new (slightly used, of course) one? Miss a payment and often that 0% interest goes away. You can’t predict the future, but you can plan for it. Plan wisely.

Vacation by credit card=the worst debt. Like the car scenario, adding credit card interest—which typically dwarfs the 5% or 10% interest most people pay on a car loan—substantially increases the true cost of that Caribbean getaway. What’s worse, you have nothing of financial value at the end; at least you can sell or trade in your car to recoup some of its cost. Better make those memories on the white sands count.

Now, what’s good debt?

Student loan=good debt (with a catch). The best investment is in yourself. If financing an education allows you to man the local bank’s drive-thru instead of the fast-food drive thru, then it’s worth the added interest. But watch what you borrow; you don’t need to pay Harvard tuition rates to be something like a teacher. School debt that dwarfs the earning potential of your career choice is not good.

Money to start a business=good debt (with a catch). Like a student loan, this is an investment in yourself. If you have what it takes to succeed in business, the sky is the limit and can be worth borrowing to get started. But also like student loans, be careful. Burdensome debt is a major reason why most businesses fail in the first year.

Mortgage=the best debt. Ok, maybe “best” is a little strong. But unlike a car, a home’s value will most likely increase over time. Plus, if you don’t own a home you’ll probably be paying rent, which can be as much or more than a monthly mortgage payment and leaves you with nothing but your security deposit in the end.

Whether the debt you rack up is good or bad, your goal should be to pay it off as soon as possible. Even good debt is bad if you don’t get eventually get rid of it.

1 comment:

B. ( said...

I first heard of the term Good Debt from Robert Kiyosaki Rich Dad series. However, many people may just take it at face value that it is ok to borrow money to invest into something which they think will be able to generate profit for them. In reality, the term Good Debt only defined the intention behind borrowing money. It does not guarantee that you will make money. There is a certain level of risk in doing so.
So get yourself educated before you start to accumulate "Good Debt".