Good Debt, Bad Debt... All Debt Sucks

Debt, Debt Control, Case-Shiller Index, Good Debt, Bad DebtMany personal finance pundits will discuss the difference between good debt and bad debt.

Good Debt

Generally speaking, good debt is debt that you incur on an appreciating asset or investment that will pay greater dividends in the future. Common examples include:

  • Real Estate
  • Student Loans
  • Business Loans

The idea is that if you borrow the money today to facilitate acquisition of these items they will go up in value. The assumption is that the future value is going to be worth more than you borrow.

Bad Debt

There are many more examples of bad debt. These are all the things you buy on credit that depreciate in value. This includes things such as:

  • Car Loans
  • Department Store Charges
  • Credit Card Purchases

The negative impact of bad debt is exacerbated when you only pay partial payments on your debt. If you purchase clothing for $40 its value drops by 50% or more as soon as you wear it. But by delaying full payment and tacking on interest charges your cost is rising over time. A $40 purchase may cost you $60 or much more over time!

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All Debt Sucks

How often does it really pay to go into debt? The most commonly cited example of good debt is home ownership. So let’s examine home ownership for a minute.

The chart above comes from Wikipedia’s entry on the United States Housing Bubble and was provide by Robert Shiller, economist, bestselling author and co-developer of the Case-Shiller index which tracks housing. He found that on average, housing values have increased only .4% on an inflation adjusted basis between 1890-2004 and only .7% between 1940-2004.

It has not been often that we’ve seen crazy, double digit increases in home values (not adjusted for inflation) such as in the late 70’s and 2005.

The oldest data I can find on historic mortgage rates goes back to 1938 when rates were first stabilized with the introduction of Fannie Mae thanks to President Franklin D. Roosevelt. They began around 3% rising to the mid 5% range in the 50’s and continued creeping up near 7% in the 60’s. Through the 70’s rates skyrocketed to the high teen and only in the last couple years return to the 1950’s era 5% range.

This means through history, in most cases that a consumer bought a house and paid off a mortgage over a 30 year span of time they paid a more in mortgage payments and interest than the house was worth.

So how is buying a house with a mortgage any different than buying clothes with a credit card?

The primary difference is that in most cases the clothing will never be worth more than the day you bought it. The gap between your total payments and its value when you dispose of the clothing will be great.

However, in many cases the gap between your total payments on a mortgage and the value of a house when you sell it will be smaller than on the clothing but there will still be a gap!

Determining the difference between good debt and bad debt is not as easy as saying the debt was for a house or car. And just because you borrow for an appreciating asset does not automatically make your debt good debt.

In my lifetime, I have yet to see a truth in lending statement that shows total payments that are less than the value of the property being purchased at the time of purchase or any foreseeable date in the future.

This is not to say there are not exceptions. Sometimes real estate is kept for a duration of time that far exceeds the mortgage. Eventually, even a blind squirrel will find a nut!

For the next post, I’ll explore those times when the squirrel gets lucky.

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Graph courtesy of Wikipedia

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