Today, we explore the difference in good debt versus bad debt.  Here are some thoughts :

• Not all debt is created equal
• Although it’s best to have no debt, debt secured by items that increase in value (such as houses) is better than debt taken out to buy things that decline in value, such as automobiles and flat screen TV’s.  The people who end up truly wealthy are those folks who tend to use their money to buy things that appreciate in value (houses, stocks, bonds, etc.) instead of consumer goods, automobiles, entertainment, and other items that quickly lose their value.

However, these assertions do not mean that borrowing on appreciating items should be done irresponsibly.

Much of the subprime mortgage crisis that our country is undergoing right now is the result of reckless borrowing on a (generally) appreciating asset.  Many folks believed that real estate would not decline in value, so they took out mortgages for more than the house was worth, in the hopes that they could flip the house for a quick profit or in order to cash-out to pay for other expenditures.

Furthermore, because real estate was not supposed to decline, the thinking was that it made sense to borrow to pay for vacation homes, investment properties, etc.  Now, many of those homes are in the foreclosure process.

Similarly, the use of margin accounts in stock investing can lead folks into trouble if there are problems at one of the companies in which those funds are invested and the price of the stock declines dramatically.

Thus, even debt on appreciating assets should be exercised with caution.

• Educational debt and business debt may be OK, in moderation.

For example, a small amount of debt to start a new business may be OK, as long as there is a clear plan as to how that business will make money and pay off the debt.

Education loans may be OK to supplement other ways of spending for college.

However, it is not OK to rack up hundreds of thousands of dollars in student loan debt only to end up working in a job making $20K per year.  There is no way in that scenario that the student loans will ever get paid off.

• Be especially careful of debt where the interest rate can adjust higher in the future; be sure to understand the basic terms of the agreement.  Many mortgages come with “teaser” rates, where the rate starts out low, but then is guaranteed to adjust higher in a few years, making the payment unaffordable for the homeowners.

To summarize, borrowing to pay for appreciating goods is better than debt to buy depreciating assets.  As always, the use of debt should be done with care.

In our next installment on debt, we will examine why the use of credit cards can be very damaging.