Bad Debt

Bad Debt
Bad debt refers to debt that is used to finance spending on non-appreciating items. This includes credit cards, auto loans and some personal loans. While these kinds of loans and financial products can be used responsibly to the benefit of the consumer, these debts still do not increase the borrower’s overall net-worth.

What is Bad Debt?

The term “bad debt” refers to debt that is used to finance spending on non-appreciating items (items whose value does not increase over time). This includes credit cards, auto loans and some personal loans.

While these kinds of loans and financial products can be used responsibly to the benefit of the consumer, these debts still do not increase the borrower’s overall net-worth.(1)

What kinds of debt are bad debt?

The most common kind of bad debt is from credit cards. The items purchased with a credit card often begin to depreciate in value the moment that they are sold. This includes items like clothing, furniture, jewelry and electronics. As these items depreciate (or decrease) in value after they are purchased, they represent a net-loss against the borrower’s net-worth.(2)

Auto loans are another kind of bad debt as a car begins to lose value the moment it is sold. Personal loans are included as a form of “bad debt”, unless they are used to finance certain transactions like real estate.

So what is good debt?

Good debt is debt that comes from investment, usually in property or in stocks. Mortgages are seen as good debt, as are loans taken out to finance purchases of real estate. These assets will (theoretically) appreciate (or increase) in value and be sold at a later date to make a profit. Debt used to make these purchases add to the borrower’s net-worth.

Student loans are also considered a kind of good debt. This is because the money spent investing in the borrower’s education should increase their potential future earnings, thereby increasing their net-worth.

Is all bad debt really bad?

No. And neither is all good debt really all that good. Houses are subject to the whims of the housing market and the same goes for real estate. Additionally, there are ways to use credit cards responsibly (like paying off the entire balance every month) and many personal loans can be used to consolidate debt or help the borrower take better control of their finances. The terms “good debt” and “bad debt” refer only to whether that specific debt can increase the borrower’s net-worth. It’s up to the borrower to take out safe loans and use them responsibly.

References:

  1. Smith, Lisa. “Good Debt Vs. Bad Debt.” Investopedia. Accessed February 26, 2016. https://www.investopedia.com/articles/pf/12/good-debt-bad-debt.asp
  2. El Issa, Erin “Why is Credit Card Debt ‘Bad’ Debt?” NerdWallet. Accessed February 26, 2016. https://www.nerdwallet.com/blog/credit-cards/credit-card-debt-bad-debt/