Well folks, some of you asked for a discussion of good debt vs. bad debt, and here we are. Susan Low’s first guest post on the subject is online, and I thought I would chime in with my opinion as well.

I personally agree that there is good debt and bad debt, although somewhere along the line Sue seemed to come to the conclusion that I think all debt is evil, I don’t. The important thing is to define what is good debt and bad debt.

First let’s look at Sue’s examples:

Paying for books? Good debt. Paying for beer? Bad debt.

Groceries while you look for a new job where your stalker can’t find you? Good debt. New stereo for your new apartment? Bad debt. … A car so you can be a good traveling insurance salesman? Good debt. The flashiest, hottest car that you can find? Bad debt.

I propose we take away the black and white of good debt vs. bad debt and add a little gray: unavoidable debt. Some things will always be unwise to buy on credit, and this includes the stereo and the beer, just as getting an education, paying for text books, and buying a work vehicle are almost always a good idea and can be considered good debt, but let’s add the third dimension…

Groceries when you can’t afford them otherwise is unavoidable debt, as is a car when you don’t need it to do your work. In these cases one needs to be frugal: shop at a discount grocery store, use coupons, buy that 1990 Honda Civic with the bit of rust that still runs like a top.

Here’s my take on the categories:

Good Debt: These are investments, and as such they will be worth more in the future than when you buy them. The future value of the item you are buying is greater than the cost of the item plus interest and depreciation. Buying a home, getting an education, and getting an RRSP loan are all examples of good debt (for you non-Canadian readers, a contribution to an RRSP is tax deductible, getting a loan to make a contribution means that your money goes to your future self instead of the government and the loan is paid off by your tax refund). Good debt pays off in the future and in the long run you benefit more for having taken the debt than if you hadn’t. Good debt is especially good if it is increasing in value at a rate that is greater than the rate that your debt increases in size from interest.

Bad Debt: These are not investments, and the things you buy with bad debt will either decrease in value or lose their value completely. This can leave you owing money for an item you no longer have or which is worth less than the amount you owe on it. Cars fall into this category (though not necessarily if bought for work, then we have to count the profit the car generates in its value to you). Most luxuries also fall into this category such as electronics, dining out, and vacations.

Unavoidable Debt: Here we have items that I would normally classify as bad debt, such as groceries, emergency expenses, and other money which you have no choice about spending and no free cash to use. While such debt is unavoidable, it is not justifiable to spend beyond what is necessary. If you have no cash for food, eating out is not unavoidable, but buying groceries at a discount grocer while using coupons is.

The funny thing about unavoidable debt is that there often are ways to avoid it. Having an emergency fund built up is a good way to avoid unavoidable debt, and often letting go of some pride and asking for help from friends and family can be another way. I have often seen people rack up debt when there were loved ones standing by to lend a helping hand. Even if you don’t want to take a handout, borrowing from family can mean no compound interest (though it can lead to a lot of strife, so do so carefully).

Letting go of pride can also mean selling off your luxuries to bring your lifestyle more in line with your income. If you are facing unavoidable debt but driving around in a new model car, maybe it’s time to ditch the car. The same goes for living in a house that is beyond your income: how many people really need a sitting room? Yet to keep up with the Joneses many mortgage a home worth more than what they should spend given their income levels.

So yes, there is good debt, and bad debt, and also unavoidable debt. The key is to know which is which and to avoid debt when possible, even the good kind if you can (and by observing my friends who put themselves through school and who are now enjoying the benefits, I can say that yes, even good debt can be avoided sometimes).

This entry was posted on Tuesday, March 22nd, 2005 and is filed under Debt Management. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.