Attitude towards debt has spawned many schools of thought. One set of people love debt. Their lives revolve around multiple kinds of debts. This includes home loan, car loan, consumer loan, credit card outstanding, personal loans and so on. There is another school of thought which tries to stay away from debt altogether. And then there is another school of thought – which lies somewhere between the two extremes. This group classifies debt as good debt or bad debt.
It is not uncommon for the people in the third school of thought (good debt versus bad debt!) to be fans of Robert Kiyosaki of Rich Dad Poor Dad fame! (Nothing wrong in that – He is probably of of the most influential persons in the personal finance space and probably molded the mindset of lot of people – mostly in a positive way)
What is this good debt and bad debt?
Typically good debt is any debt that can help you create assets- something that can increase a person’s net worth. Bad debt is a debt that helps you buy things that are depreciating in value.
(Here is how Investopedia defines it)
- In few things, it is fairly obvious that they are bad debts – e.g. personal loans, or consumer loans or credit card debt.
- Some debts are considered to be good debts – like home loan (jury is still out!) or education loan or business loan.
- Few things like car loan fall into a grey zone – Some consider it to be a good debt, but many others consider it to be a bad debt.
The grey zone in the debate
While it is easy to say that there is good debt and bad debt, it real life it is not so simple. Sometimes your need at that point of time can classify debt as good or bad. Few other times, you can know only with benefit of hindsight!
Few examples –
- If you are buying a home loan to invest in a home. How would you classify this debt? Home is (believed to be) an asset. It can create steady rental income. It can appreciate in value and give good returns. But at the same time, real cost of owning a home can be high. Rental yield can often be small. Maintenance can cost lot of money. Appreciation may be small. Returns on investment may or may not be in alignment with your expectations & cost of borrowing!
- You are buying a home for for staying (as opposed to buying in previous case). And you don’t have enough money. In this case you may have no other option but to take a home loan. How do your view this debt?
- Buying a car on debt is something that is often contentious. Car is a depreciating asset and its value decreases with time (highest depreciation is immediately after you buy a new car!). With that rationale, car loan is a bad debt. At the same time, for some it is a necessity and one may not have that much cash at that point of time. How do you look at it?
- Someone may take a loan to speculate in stock market and make good returns. (which more than overs up for the cost of borrowing). For that person, it is a good debt. At the same time, one can’t predict movement of markets (historically, in long run, they have been good – often more than the cost of such borrowing – but there is no guarantee!) and most people do burn fingers with such debt. For them it is a bad debt. (My take – Avoid debt for speculations – Risks are too high!)
- You have a medical emergency at home and unfortunately, need to borrow money n form of a personal loan. Can you classify such debt into good or bad? (Ideally health insurance, emergency fund should help but it may not always suffice, or worse still, you may not even have it!)
Some debts, depending upon the context can be good or bad. Some debt are good or bad with the benefit of hindsight. And hindsight is 20/20 vision!
What are your thoughts?