Good Debt vs. Bad Debt

When used intelligently, debt can be of tremendous assistance in building wealth. One of the secrets, therefore, to being smart with your money is to differentiate between good debt and bad debt. While the differences often seem logical, it is a logic that is apparently missed by many Americans.

"When you buy something that goes down in value immediately, that's bad debt," says David Bach, CEO of Finish Rich Inc. and author of "The Finish Rich Workbook. "If it has no potential to increase in value, that's bad debt."

Some of your debt might be considered an investment. You're probably thinking, "How can anything as bad as debt be considered an investment!" If you took on the debt to purchase something that will increase in value and can contribute to your overall financial health, then it’s very possible that debt is a good one. The term is "financial leverage", and the principle is that money borrowed is invested in something with the intent to earn a greater rate of return than the cost of the debt’s interest.

For example, since homes usually appreciate in value, the mortgage loan you take out to pay for the home is a good investment, and a good debt. Another example of a good debt is a student loan taken out to finance a college education. Earning a college degree usually means that you’ll make more money over your lifetime, and easily covering your initial costs

Just like there is good debt, there is bad debt too. When you use debt to finance things that can be consumed, or that decrease in value, you aren’t accumulating good debt. This is the kind of debt that creates an unhealthy financial situation. Credit card debt is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never accumulate debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, you should pay the balance in full each month.

Even debt used to finance a vacation is bad debt. Even though it might help you feel better and be more productive once you return, a vacation does not appreciate in value. Don’t use debt to pay for a vacation and especially don’t use it to pay for a vacation you can’t afford.

In short, bad debt usually involves the purchase of something that depreciates in value, even though these situations are sometimes not easily avoidable.

In most cases, auto debt is usually regarded as bad debt. While most people need an automobile, and the ultimate cost of an auto is higher than many people can pay in one lump sum, the way people go about it -- namely, purchasing more car than they need -- turns it into bad debt. On the other hand, bad debt can in some cases turn into good debt. For example, if you use debt to buy a car that gets better gas mileage than your old vehicle, you could end up better off financially.

Worsening the situation, experts say people tend to borrow to buy cars before homes, though for most people, their first major loan is a car loan which is guaranteed to go down in value.

One of the reasons so many Americans seem mired in bad debt (researchers report that the average American carries approximately $8,400 in credit card debt) is that financial education is virtually nonexistent. Common-sense financial knowledge isn't taught in school, many times not even college remarkably.

Compounding this, many people are getting into debt before they even have a job. Young people need to be taught to treat credit cards like emergency safety nets, and if they have to use it, to immediately revise their budget and pare back on nonessential spending. Racking up a balance and paying the double-digit interest on it can happen faster than many suspect, and this notion must be communicated to teens.