Good Debt Versus Bad Debt

Posted On: 2006-12-19Length:

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Hello, and welcome to Money Girl's quick and dirty tips for a richer life.

Today I'm going to be talking about good debt versus bad debt. Many people think that all debt is bad and is something to be avoided and paid down as quickly as possible. But there are really two types of debt. Good debt, and bad debt. Now one quick and dirty rule of thumb for identifying whether a particular debt is good or bad, is to ask yourself whether the debt is financing something that is appreciating, or depreciating in value. If the debt is financing something that is going up in value, it's usually good debt. If it's financing something that's losing value, on the other hand, it's usually bad debt. Examples of good debt would be the mortgage on your home and a loan for college education. A mortgage finances a house, an asset, that over the long term goes up in value. And a student loan finances an education, which is likely to result in a better paying job, and better employability down the road, at least that's the idea, anyway. An example of bad debt would be a car loan. Most new cars lose more than half their value within the first five years after being bought. A second example of bad debt would be money that you borrow to buy something that's losing value that you can actually afford to buy without a loan. Like a dinner out, for example.

Ok. So that's the difference between good debt and bad debt. But what's the smartest way to pay off debt? When tackling debt, it's a good idea to start paying down your highest interest loans first, especially if they're financing items that are losing value. For almost everybody, this means paying down your highest rate credit cards first. After that you can work on paying off your lower rate consumer loan, like a car loan, after you've paid off these types of debts. Your next step would be working toward paying off your good debts, if, and this is a big if, if you don't have a better use for the money. If you can invest your money at a higher rate of return than the interest rate on the debt, you're usually better off investing the money instead, and paying down the debt more slowly. And if you do have a mortgage, you don't necessarily want to rush to pay it off more quickly. Mortgages typically have low rates compared to other types of debts. And, in the U.S. and several other countries, the interest you pay on your mortgage is tax deductible...