THE BLOG
06/12/2009 07:41 pm ET Updated May 25, 2011

Is Your Debt Naughty or Nice?

A reporter's recent query left us grinning ear-to-ear with holiday cheer: Has the dividing line between "good debt" and "bad debt" changed in today's rocky economy?

The short answer is no. What has shifted - as indicated by the very nature of this question - is people's willingness to admit that such a dividing line exists in the first place. With last week's stunning news that US consumer debt levels had declined for the first time in over 50 years, it is clear that "debt" has finally come to be seen for what it is, a four letter word that should be used with extreme caution.

In years past it was common practice to argue that "good debt" was any debt used to purchase long-term assets (think homes and education). "Bad debt" was anything spent on short-term consumables (think consumer electronics, vacations, and clothing). What was missing in this definition was an acknowledgment that - as with eating chocolate and playing video games - too much good can be bad.

So how do you know if your debt is naughty or nice?

Nice debt is debt you can afford. This means debt that has monthly payments sufficiently low that you can pay down your debt while meeting all your other necessary living obligations (and a few fun ones too) with cash. Examples of incurring good debt would include:

• Buying a house you can comfortably afford - for most people that means a house with a purchase price that is roughly three times their annual household income.
• Buying a basic car to get you to work - for most people this means a car with a purchase price of roughly 1/3rd (or less) of their annual income.
• Paying for an education that will lead to a meaningful increase in your income and that can be paid off in a reasonable amount of time - the ideal is to be able to pay off your student loans in 15 years, spending 10% or less of your gross (i.e. before-tax) income a year.

Naughty debt is the kind that suffocates you, forcing you to cut back on other essential living expenses to pay it off. Naughty debt stretches you so much that you end up making your monthly payments late, thus damaging your credit score. It pains us to say, but the harsh truth is this:

Yes, Virginia, you can incur bad debt for good things.

Since we've covered housing in previous posts, let's use higher education as an example. Suppose you come out of a private graduate program with $150,000 of debt (click here to read one such story...) Let's say you then take a job making $50,000 a year. It doesn't matter how great your education was - setting aside 10% of your annual gross income (or $5,000 a year) for debt pay down, those student loans will be a financial noose around your neck for decades to come.

With the sky-high cost of higher education, it's not uncommon for people to be paying off their student loans for multiple decades. We are not saying this situation is acceptable. It's not. As a nation we must make quality education affordable for all. But that's another story, for another post. Our point here: the answer is not to blindly take on exorbitant levels of student loan debt anyway.

Becoming the CEO of You, Inc.

When analyzing the capital strength of businesses, investors focus on metrics such as the interest coverage ratio. That shows how easily a company can make the interest payments on loans it may have outstanding to fund its business. The higher the coverage ratio, the stronger the company's financial position. In today's economy individuals are being forced to think about their own debt loads the same way. In this gut-wrenching economy it has become crystal clear that the only "good debt" is debt that you can comfortably service (e.g. make monthly payments on) with your existing cash flow. That means that even worthy assets like your home and your education may not make the cut if you are not earning enough to pay for them. This represents a radical shift in thinking. As we all strive to live within our means during these difficult times, the question of whether your debt is naughty or nice is a powerful one indeed.


Manisha Thakor & Sharon Kedar are the co-authors of ON MY OWN TWO FEET: a modern girl's guide to personal finance.