Why All Debt Is Not Created Equal

debt

In the past, I’ve written a little bit about debt and some of the ways you can pay it down over both the short and long-term. Debt can be a scary word, one that evokes images of myself on a hamster wheel working as hard as I can, but never really outrunning the debt payments that pile up behind me. While debt can sometimes limit flexibility and freedom to make certain decisions, not all debt is inherently evil or useless, and in fact, it can help people purchase a home or an education. The realities of debt are hardly that black and white, and learning to make the distinction between responsible and irresponsible debt can help you make more sound and informed financial decisions.

A while back, a friend of mine (who has sizable school loans) told me something about her debt that I found difficult to believe — accruing debt for her degree, and embarking on a long-term payback period, could actually be a good thing. Hearing that was jarring. How could debt be good?! She went on to explain that the kind of debt she took on during her years at college meant that, yes, she graduated with sizable school loans, but she felt that it provided her with something that would grow in value — her career and professional experience. In her opinion, this “good” debt was an investment in a career that would likely generate gross lifetime earnings that would be far more than enough to pay back the loans, and involved a good tradeoff of risk and reward.

While taking out school loans is certainly NOT the right choice for everyone, she believed that her long-term debt provided her further value as it afforded her an opportunity to show credit agencies that she was responsible, paid bills on time, and essentially, could take care of her shit (for lack of a better word).

While I myself am not a financial expert in any way, I’ve learned a lot about what it means to borrow money in the immediate to help fund a dream, invest in a future, and strengthen my professional endeavors by buying the tools I need. Debt has to be used intelligently, and it’s essential to consider the reasons why you take debt on and what you can gain from doing so over the long-term. It’s not about an amount of money that one party simply borrows from another — it’s much more nuanced.

For example, there are certain investments that might require you to take on debt, but the potential return on that debt and what you can build with that capital, has the potential to provide you with more money. I was looking at this site, which provides a chart that very briefly compares good and bad debt, and uses examples to illustrate it. Here are some very high-level examples of “Good” and “Bad” debt to help you understand.

Bad Debt:

  • Credit card debt
  • Retail/store credit card debt
  • Very high interest credit card debt
  • Used to purchase things that decrease very quickly in value
  • A luxury holiday you can’t afford
  • A new car you can’t afford

Debt.org describes “Bad” debt saying:

“Bad debt is that which does not increase wealth and/or is used to purchase goods or services that have no lasting value. While no one would argue against ever buying a non-essential item, you can put yourself into crippling debt too easily by not restraining yourself from buying luxuries that you don’t really need, or that exceed your income or your ability to pay for in a timely manner.”

The problem with bad debt is that there is a lot of gray areas that are tricky to navigate. However, you should ask yourself essential questions like, “Do I need this,” “Have I shopped around for the best deal/interest rate/conditions,” and “Is there any prospect that this will pay for itself in the long run?” These questions can help you understand if the debt you’re taking on is a smart investment.

Good Debt

  • Low interest rate debt
  • A debt that is taken on to buy an asset that will provide value over the long-term
  • A house, education, investment property
  • Investing in your own business

Again, Debt.org further clarifies this distinction, and describes “good” debt saying:

“In general, good debt is that which increases your net worth and/or helps you to generate value. Good debt allows you to manage your finances more effectively, to leverage your wealth, to buy things you need and to handle unforeseen emergencies.”

Generally speaking, it’s safe to determine good debt when thinking about whether or not it will  leave you better off in the long run. The phrase, “It takes money to make money” is an apt one that helps describe what “good” debt is. Good debt means borrowing money wisely. When considering whether or not the debt is the “good” kind, The Money Advice Service says, “You should have a clear and specific reason for taking it out, and a realistic plan for paying it back that allows you to clear the debt as quickly as possible, or in a series of regular and affordable payments (eg for a mortgage).”

The concept of “good” and “bad” debt is one that took me a long time to figure out, and frankly, an idea that I’m still learning and understanding. While I know that taking on “good” debt is what I should be doing if I want to invest in myself and my career for the long-term, it still feels scary to have to navigate payback plans, interest rates, etc. The most important thing you can do is to make decisions carefully and consider all the ways in which your financial choices now will inform who and where you are down the road.

Some helpful resourceful reads:

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