What Is The Difference Between Good Debt and Bad Debt?

While speaking with a client yesterday, I explained the difference between good debt and bad debt. I used to think that all debt is bad, and I still do at times. In a nutshell, good debt is the debt you have on an asset that is appreciating, like your home or a loan for education. The idea being that an investment in a home will appreciate in value over time, and likewise, a good education will provide opportunities for economic advancement.

Bad debt is debt on an asset that is depreciating, like a car or boat loan. As we all know, most new cars and boats lose half their value within the first few years. Additionally, debt on credit cards, store cards, gas cards, where there is no asset, is also bad debt. The distinction is very important, and I believe often overlooked, when deciding which debts need to be paid off.

The question is: Which debts do you start paying off first? Good debts or Bad Debts? In my opinion, you always start with the bad debts and make a decision not to go into anymore debt. That is the hardest part, making the decision to throw away the credit card crutch and start living on cash. I know there are a million excuses for having a credit card, and quite frankly, some of them are legitimate, but discipline is what I am talking about here. Yes, it’s o.k. to use a credit card to reserve a rental car, then pay cash, don’t leave it on the card. Little things like that.

When deciding which debts to pay off, there are two schools of thought. First, you have the school of thought that tells you to pay off the credit card or loan with the highest interest rate. While this may save you a little bit of interest over time, it may not be the best or most sustainable idea. What if your largest loan also has the highest interest rate? Then you may begin fighting an unsustainable battle. The second school of thought is to pay off the credit card or loan with the smallest balance. Why? The answer is part psychology and part emotional. It demonstrates that you can do it, and that it is the start to a different lifestyle, a debt free one. Once that debt-killing snowball starts rolling downhill, it gains momentum.

In either school of thought, once the balance is paid off on that first loan, then you take the monthly payment that you were making on the first loan and apply it to the next loan. Simply put, you begin to kill debt at warp speed.

Once all the bad debts are paid off, you have to make a decision. Do you want to continue killing debt by tackling the good debts or can you invest your money at a higher rate of return so that your money is making money instead of being used to pay debts. That, my friends, is a story for another day.