Rating your debt, from best to worst

Have you ever done this?

Have you ever taken all of your recent bills and sorted them into two piles? One pile is your “good debt” pile and the other is for “bad debt” and to celebrate the difference your good debt gets to pick what you watch on TV that night, while your bad debt has to clean out the gutters and go to bed early?

Of course you haven’t. That’s terrifically crazy.

Your debt is just your debt, right? There’s no shading there. It’s just debt. It’s all bad. Right?

Not so much. You see, debt can be good, too. Not the John Wayne/Luke Skywalker kind of good, mind you. More like the Brussels sprouts and jogging kind of good. Good for you. Not your favorite thing by any stretch, but the kind of good that helps you live a better life. And you want a better life, don’t you? Well, part of living a good life is making sure you have the right amount of good debt and bad debt.

So which debt is good and which debt is bad?

The three happiest, healthiest, friendliest debts

We all know that debt comes primarily from borrowing money to buy goods and services that we can’t afford to pay for with cash. Some folks are able to manage their entire lives never needing to borrow a dime, which is great for them, but pretty impractical for the rest of us. There are too many important, “big ticket” items necessary to modern life to live without borrowing. Fortunately, those major purchases form the core of what’s considered good debt.

• Mortgage
• Student loans
• Business loans

When you’re considering taking on new debt, ask yourself, “Will this debt help increase my net worth OR help me generate future income?” If the answer is yes, then you’re about to engage in a form of investment, and investment debt is the “best” kind of debt to undertake.

Now, let’s keep in mind that investments don’t always pan out. Businesses fail, property values sink and job markets dry up. No matter how good a type of debt may be, it’s still debt and it can still become overwhelming. But, that said, these are varieties of debt that have the potential to pay for themselves. They provide clear value to your life and usually come with relatively low interest rates.

Nobody really wants to have debt, but if these are the debts you have, you should feel pretty okay about that.

The best debt you hopefully don’t have

• Medical bills

Medical bills are an investment in health, either for you or your family, so they’re really the best debt hands down. Always make health and wellness the top priority.

That said, medical bills kind of stink. First of all, they mean that someone is unwell, which is never any fun. Secondly, you can’t really plan for them (at least not as well as you’d like to). And thirdly, they can get out of hand very quickly, leaving you suddenly and deeply in debt.

Some medical offices will finance your out-of-pocket expenses by making you open a special credit card to cover the procedure. Be careful with these cards – the terms can sometimes be less than favorable. Whenever possible, ask if you can arrange a payment plan that’s amenable to both sides.

Two debts that want to be good, really they do

CNN.com defines good debt as “anything you need but can’t afford to pay for up front without wiping out cash reserves or liquidating all your investments.” That’s something of broader, less-nuanced definition of “good.” Based on that definition, you might have thought these next two debts belonged in the first bracket:

• Auto loan
• Home equity loan

So why are these two good, but not quite as good as the first three? Let’s start with auto loans.

Most people need a car. And most of those people can’t afford to buy a car with cash. So an auto loan is necessary to fulfill a need, and, I suppose, you could even make the argument that it helps you generate income (by taking you to work OR by being taco truck, which is really the best of both worlds).

But the big problem with cars is that they depreciate in value. Quickly. They’re an investment (and usually a very necessary one), but it’s a cost that’s eventually lost to the sands of time, much like those Brussels sprouts.

Home equity loans are tricky, and how good they are for you really comes down to what you use them for. If you’re improving your home and increasing its value, that’s another investment that can pay for itself. So that’s good.

But what about financing your child’s college education? Or buying a new car? You might be able to get a home equity loan for a lower rate than an auto loan – so should you? That’s up to you, but always keep this in mind – anytime you borrow against the value of your home you put your home at risk, because if your economic fortunes ever shift and you find you can’t make your payments, you won’t lose your car (or whatever it is that you’ve financed) – you’ll lose your house. So please be careful!

Debt from the wrong side of the tracks

• Unsecured loans
• Store cards
• Credit cards

No debt has to be bad. As we discussed earlier, the circumstances behind a debt go a long way toward defining it as either good or bad. And these three debts in particular, when used correctly, can be good. They can serve your needs.

They just happen to have more potential to go bad. Very bad.

Ultimately, it usually comes down to impulse control and a proper spending plan. If you know how to use credit and how to live within your means, then credit card debt can be a beneficial tool to have at your disposal. If you have poor impulse control, however, and aren’t so hot with budgeting, then your credit card debt can get out of hand faster than you’d think possible.

If you’ve been living with these kinds of debt for a while now, don’t panic! (They can sense your fear.) Just remember to always stay current with your payments and try to avoid adding to the debt as best as you can. If you’re already weighed down by a high APR or unwieldy payments, consider speaking to a credit counselor to see what could potentially be done to get your payments back within your budget.

Debt-That-Must-Not-Be-Named

• Payday loans

Like all debts, payday loans exist because they fulfill a need. They also happen to have ridiculously high interest rates and often lead to an endless cycle of borrowing that costs consumers an exorbitant amount to break free from. Consider all possible alternatives before getting yourself entrenched in a payday loan.

When it comes to debt, remember what my doctor tells me about cholesterol every year: control the good and minimize the bad. And as always, if your bad debt is getting out of hand, free counseling is available 24/7 here at Money Management International.

Need help understanding your student loans?  Unsure what programs are available to help you pay back your debt and get your finances in order?  MMI now offers student loan counseling.  Our trained counselors can help you understand your options and create a plan to get your student loan debt under control.  Visit our Student Loan Counseling page for more details.