Before the Great Recession of 2008 overturned many long-held financial beliefs, it wasn't uncommon for people to differentiate between "good debt" and "bad debt." The thinking was that certain kinds of debt were worth taking on because you come out ahead in the long run. Buying a home and financing a college education were two notable examples.
But when home values began to plummet and the cost of a bachelor's degree soared into five or six digits, those once-safe investments in your future suddenly seemed risky or unattainable.
Four years later, it's a good time to step back and examine the concept of good debt vs. bad debt and why, in certain cases, acquiring debt may still make sense -- provided you plan carefully and don't exceed what you can reasonably expect to repay.
This simple distinction still applies: Taking on so-called good debt can help boost your credit rating or allow you to buy something that will increase in value over time, whereas bad debt often fuels the purchase of items that are disposable, unnecessary or rapidly depreciable.
Good debt might include:
Building credit history. One of the best ways to build a strong credit history is to show lenders you can pay off debt responsibly -- possibly by taking out a student loan to finance higher education or opening a credit card account and using it wisely. Lenders are more apt to qualify you for a mortgage, car loan, or other large debt if you've demonstrated sound repayment behavior. Plus, they usually reserve the best rates and terms for good-risk candidates.
Keep in mind, though, that carrying excessive loans or multiple high-limit credit cards could harm your credit rating, since lenders might worry you're taking on more debt than you can repay.
Investing in your future. According to the U.S. Census Bureau, the average college graduate earns $47,422 a year, compared to $26,349 for high school graduates -- a difference of $21,073. Using simple math, some calculate the difference in total earnings over the course of a 40-year work life as more than $800,000.
However, such estimates don't factor in the crippling student loan debt many graduates (and drop-outs) face -- often for decades -- or their inability to find work in a chosen field during difficult times. But still, according to the Bureau of Labor Statistics, the unemployment rate among college grads is roughly half that of high school grads -- 4.5 percent vs. 8.4 percent (it's a whopping 12.2 percent for those with no high school diploma).
Bottom line: College is still a worthwhile investment for many people if they don't go overboard on loans and choose a degree with good earnings and employment potential. My recent blog, Can Your Family Afford College?, discusses issues families should weigh when considering higher education alternatives.
Buying a home. Before the real estate crash, homeownership was considered good debt because historically, when someone finally paid off their mortgage, their home was usually worth much more than the purchase price. For many, this probably still will be true, unless they bought during the market upswing or are forced to sell before prices can recover. After all, mortgage interest rates are historically low and interest and mortgage points are still tax-deductible.
Just make sure you don't buy more house than you can afford. On top of your monthly mortgage payment factor in expenses like property tax, primary mortgage insurance, homeowners dues, utilities, repairs and furnishings -- and if you get an adjustable rate mortgage, calculate how high rates could climb. Bankrate.com's Mortgage Basics provides a good overview, including asking the basic question, "Should you buy or rent?"
Bad debt. What qualifies as bad debt hasn't really changed since the recession -- it's just that budget-conscious consumers are paying more attention now. Meals out, excessive vacations, and unnecessary clothing or electronics -- wants vs. needs -- all qualify if you're spending beyond your means. Basically, if you can't pay the bill in full within a month or two, reexamine whether it's a worthwhile expense; particularly if you don't have at least six to nine month's pay stashed in an emergency fund or you're trying to save for a car or home.
And speaking of cars: Common wisdom used to consider buying a new car to be bad debt because they lose 20 percent in value the minute you drive off the lot. However, today's vehicles are much better constructed and people are holding onto them much longer, so quality used cars have become harder to find.
A friend of mine was car shopping recently and found that certified, low-mileage used models of the car she wanted cost only about $1,000 less than a new vehicle. Plus, her bank's interest rate for a new car loan was almost two points lower than for a used car. That's a case where buying new probably makes sense. Just pick a model with high resale value whose monthly payments -- and insurance, gas mileage and maintenance -- you can afford. Sites like Kelley Blue Book, Edmunds and Cars.com are good places to start your research.
Bottom line: Used correctly, certain debt can work in your favor. Just make sure you're managing the "bad" debt so it doesn't manage you.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial adviser for specific information on how certain laws apply to you and about your individual financial situation.