Determining Whether Debt Is Good Or Bad - Part 2 of 3
In part 1, I discussed how good debt can lead to enhancing your return on investment (ROI). Bad debt is typically debt that you incur to increase your lifestyle before you have earned it. This comes in many different forms. Most people immediately think of credit card debt when they think of bad debt. This is usually true but it is not alone in setting you up to obtain something today and pay for it and financing in the future.
I regularly see people that have used student debt as a combination of good and bad debt. The good side of student debt can be undeniable. You are leveraging another’s assets to obtain an education that will provide you substantial return the rest of your life. The question is, how much was used strictly to get you ahead and how much was used to live up college life. Using funds acquired through student debt to host a Friday night keg party, go out to the bars or go on an expensive Spring Break trip are easy to do when you are young and are usually regretted years later when you are still paying for them.
As you will see in part 3, items like low interest car loans can make good sense mathematically instead of taking money out of your investments. Where car loans become bad debt is when you are using it to purchase a car that you could not afford today otherwise. In this situation you are simply using your future earnings to purchase a car that is not an appropriate part of a lifestyle you have earned yet.
What confuses many people in determining good and bad debt is primary real estate mortgages. Using a mortgage to purchase a primary residence is a lifestyle move, not an investment. Purchasing a home allows you the comfort to dictate far more than you can if you are a tenant. What most people miss is that the cost of owning your dwelling is far more costly than just the mortgage and is rarely made up by the growth in the real estate market and principle payments being made (this is a topic for a future blog post). I equate a mortgage to prepaying your rent. If you are not going to be in a home after your mortgage has been paid off, thus reaping the benefits of prepaid rent, then you should evaluate the financial benefit of purchasing.
Why does debt for lifestyle matter so much? As many have heard me say, when you increase your lifestyle today you are affecting your future twice as much as you affect today. Spending money with future earnings not only removes those dollars from the future but creates a higher lifestyle expectation when you get there.
In Part 3, I will discuss the factors when you already have debt.