Good Debt vs Bad Debt

At its most basic all debt is bad, but we all know that sometimes the cost of not going into debt can be higher than the cost of the debt itself so we must on occasion make a decision. Are we willing to become indebted to someone else for something that we need or want. This decision can sometimes be a very easy one and sometimes it is far more complex but it is important that we stop to think about this question in a logical way before we borrow money. The three questions I ask myself before borrowing money are, Do I have to have this? Am I unable to afford this without borrowing?, and Can I repay the debt? If the answer to all three of these is yes then borrowing may be the solution, if the answer to any of these is no you should consider the debt bad and avoid it.

The most basic question is, Do I have to have this? Remember that whenever you borrow money you are mortgaging your future against the present. You are forcing yourself to work harder and longer for something you have likely already used. You should also remember that borrowing is at its most basic buying money at a bad price. In many loans you are paying a dollar fifty or more for every dollar of value. So what are things that you need? This is of decision that you must make for yourself, but in its most basic it is, food, shelter, transportation and education. Borrowing for any of these may be a reasonable choice though it is never the best choice.

The second question is, Can I afford this without borrowing? This is a serious question because as already mentioned it is far more expensive to buy on credit than to buy with cash and so by saving for those things you want you will have more money to spend, more leisure time and far less stress. This means that using the credit card to buy pizza is probably a bad idea, but borrowing money for a house, car or education may be a reasonable choice, though even in these cases it is best to pay as much as possible with cash.

Which leads to the third and most important question of good and bad debt. Can I repay the loan. Borrowing money is a tricky thing, and with so many bankruptcies and foreclosures it is clear that many people who believed that they could repay loans are now unable to so you should think long and hard about your ability to repay a loan before making it. Even if this is something you need and you are unable to pay for it any other way if you cannot honestly say that you will be able to repay it then it is a bad debt. Most important in this decision is the assumption that you will never make more than you do now, and will possibly make less. This may not be true, but for the sake of debt it is an important assumption not only because it allows you to avoid overreaching but because it allows debts to be paid down faster if your income increases.

The question of good and bad debt then comes down to a simple point. Debt is never the optimal choice but often it is the only reasonable choice. In these cases you should focus as much as possible on how you will repay this debt without costing any more of your future than necessary.