You make choices every day. Do I want to eat healthy or not? Do I want to go for a run or not? Do I want to get to sleep early or not? Often it's a choice between good for you or not so good for you. Debt is no different. There are good choices and bad choices.
I have to admit, when I first heard the terms good and bad debt, I didn't really understand what it meant. I thought all debt was to be avoided if possible. Of course, most of us don't have that option available to us - I know I certainly didn't.
But if debt for certain purchases allows you to build your wealth, then it can't be all bad right?
Getting a good education so you can potentially make more money over your lifetime seems like a pretty good investment. But weighing the cost of the education versus how well the career path your choosing is going to pay is an important analysis to do before taking out a ton of student loans. Going to a top private college to get a degree and go into a field that is known for not paying well probably isn't a good trade-off. Deciding to go to a community college might be a smarter decision.
Buying a house, if you plan to live in it for a relatively long period of time, so it has time to go up in value before you sell it, is the debt most of us accept as necessary. However, in the financial crisis of 2008, we saw housing prices plummet, putting many people into difficult situations. Other real estate that is purchased as an investment, like an apartment building or warehouse, that will provide an income stream is another use of debt that can be positive.
Starting your business, where you anticipate making more money, is another way to utilize debt. If you have a great idea that takes off, it's definitely worth borrowing. If it's really successful, you might even get to do an Initial Public Offering (IPO), where you sell shares of the company to the public and you get the money!
On the other hand, when debt is used to buy something that won't go up in value or generate income, it's considered bad debt. In particular if you are going to consume what you're purchasing, that's a bad exchange.
Buying things like a car, clothes, vacations, eating out, fine wine, etc. that you can't afford to pay for at the time of purchase, should be carefully thought through. Although, I remember when I was early in my career, hearing one of my more senior colleagues say that he would never buy a vehicle if he couldn't pay cash for it. I thought to myself, if I waited to have the cash, I'd never own a car...and I needed one.
So you also have to weigh your personal circumstances. A car that gets you to work and to a grocery store where you can buy healthy foods may be a necessity. But as you look forward, trying to plan for these purchases and save in advance is the best answer.
I consider this to be the most evil of all debt. It's a vicious cycle. If you can avoid this one, by all means do. The interest rates on credit cards are astronomically high. And they lure you in with minimum payments. It can get out of control so fast it will make your head spin. DON'T DO IT.
There are a few different ways to tackle debt. Let's say you have debt on 2 credit cards - one for $500 at a 12% interest rate and another for $3,000 at a 14% interest rate; student debt of $15,000 at a 5% interest rate; mortgage of $200,000 at a 3.5% interest rate. Where do you start?
The Snowball Method - This is where you pay off the smallest piece of debt you have first. So you would pay off the $500 credit card first and continue making the minimum payments on everything else. This gives you quick feeling of success. You get to stop paying on that credit card once it's paid off.
The Avalanche Method - This is where you pay off the debt with the highest interest rate first, while still making minimum payments in the rest. So you would work at eliminating the $3,000 credit card debt first. Then move on to the $500 credit card. This should result in you paying less interest over time, thereby saving you money. However, you don't get the quick fix that the Snowball method provides.
Part of the puzzle is to understand what is going to be more motivating for you.
Ultimately, the best choice is not to get yourself into a situation where you have taken on bad debt and it's circling out of control. Be thoughtful and cautious when it comes to debt. Think it through carefully. Unfortunately, you may have thought you had it all planned out and something like a Pandemic comes along and changes the dynamic entirely. Pivot and re-plan.