Understanding Good vs. Bad Debt: A Comprehensive Guide

Have you given any thought to the 'types' of debt that you may have? We're not referring here to credit card accounts versus mortgages versus car loans – at least not per se. What are we talking about? Well, there are many different kinds of debts, but they all fall into one of two general debt groupings – good debt and bad debt. You're probably thinking right about now that the best type of debt to have is 'no debt,' and you'd be quite correct. But since we are a nation (and, indeed, a world) in debt, we should be wise to the types of debt that we incur, and do our best to use the good kind of debt to our advantage and minimize as much as possible the bad kind.

First, let's define the parameters that 'good debt' falls into. According to many financial experts, any time you make a purchase that will produce revenue, tax deductions, or both, it's generally considered to be good debt. The three major areas in which you can obtain good debt are buying a home, paying for your kids' college education, and financing a car. For example, purchasing a home is good in that the property should appreciate over time (the current condition of the housing market notwithstanding), allowing you to utilize it as a tax shelter. Furthermore, you can take equity out of the home, if necessary, to pay off high-interest unsecured debt. Thus, borrowing on your home at a low interest rate to get rid of higher rates is also good debt.

The same holds true for purchasing a car or paying for your children's college tuition. Both are investments that (generally) carry low interest rates; but, more importantly, you're investing in your children's future earning potential and the debt incurred will ideally yield a high-paying career down the road.

Another reason that good debt is important is because it has a direct bearing on your FICO score. If you pay your debts on time, this will positively affect your overall credit rating and produce a higher score. In turn, a good credit score will increase your chances of buying a new car or obtaining a new home mortgage at a substantially lower interest rate, thus saving you money each month and over the life of the loan.

Good debt only turns to bad debt when you become overwhelmed with monthly bills that you cannot pay. Applying for additional credit may decrease your FICO score and, in cases where payments are frequently missed, your credit report will show a negative rating.

Credit cards and other unsecured or open-ended debt are generally considered to be 'bad debt.' This is because they typically carry much higher interest rates than the other debts mentioned here, and they're used mainly for convenience. As such, the purchases made with these kinds of instruments will not produce any revenue or tax advantages to offset the interest that you'll pay. This type of debt, needless to say, should be minimized as quickly as possible.

There's no way of really getting around it; today, most of us are carrying some measure of debt. But the type of debt you incur is at least as important as its amount. Be sure to choose wisely. If you must have debt, make sure that it's doing all it can to work for you, and not against you.