Most of us have heard personal financial advisors divide debt into two broad categories:  “good debt” and “bad debt”.  In this framework, “bad debt” represents that debt which is incurred to finance short-term consumption while “good debt” is used to purchase assets or increase earning capacity.  In reality, this division is overly simplistic and may even be harmful.

Consumer debt, incurred to finance consumption, clearly has long-term negative impacts.  Making purchases today with the hopes of being able to pay it off tomorrow encourages poor purchases and decreases future earnings by replacing investment returns with an interest burden.

But what about “good debt”?  Doesn’t it make sense to incur debt for housing, education, and autos?  Maybe.  But the answer isn’t unambiguously affirmative, and by convincing ourselves that debt we incur in these areas, we may unintentionally damage our finacial futures.  Let’s look at each of these in turn:

Housing:

Let me lay out a few arguments we often use to support mortgage debt:

• Buying a house is a great investment.  Prices are bound to go up, maybe as much as 10% per year.
• Mortgage debt is a great tax shelter.
• You should buy as much house as you can afford.  This will enable you to earn more when you sell it.

The current housing crisis clearly points out the fallacy of this line of thinking.  Housing prices have traditionally increased at roughly the rate of inflation, or about 3.5% per year.  While this can add up over time, especially with leverage, it doesn’t make housing a slam-dunk investment.  Many people buying into this line of thinking bought much more house than they could afford.  Recent studies by the US Census show that 38% of mortgage holders pay more than 30% of their income in mortgage payments, the level at which the US Government considers housing expenses an unreasonable burden.  And 15% of mortgage holders pay more than 50% of income to mortgage payments.  Even without declines in housing prices, these borrowers would be in trouble.

To avoid falling into this trap, consider housing an expense: buy what you can afford, using standard banking ratios of 28% of income as a good guideline for the maximum monthly payment.  You will have adequate housing, while still being able to afford other financial goals such as saving for retirement, education expenses, etc.

Student Debt:

Student debt is a good investment, since college graduates earn significantly more than those without a college degree.

This is true, but recent graduates have increased their level of debt to the point where their debt levels are often unmanageable and recent grads have become one of the quickest growing segments of new bankruptcies.  According to the American Association of State Colleges, two out of three college students graduate with debt and the average borrower who graduates from a public college owes $17,250 from student loans. Ten years ago, the average student borrower attending a public college or university graduated owing $8,000 from student loans (adjusted for inflation).  Students are even paying for college on their credit cards, which have significantly higher interest rates than subsidized or unsubsidized federal student loans. A recent survey by the National Association of College and University Business Officers found that credit cards account for 18 percent of tuition payments.

When not managed wisely, this debt becomes an impediment to buying a car, purchasing a house, getting married, or attaining other financial goals.  To ensure that your education is an investment rather than a burden, chose a school that meets your budget and chose an area of study and career that will enable you to successfully pay off your debt.  Take advantage of low-cost subsidized loans rather than private educational loans, and keep credit card debt to a minimum.

Autos:

Most people today finance cars rather than paying cash.  Our autos are an asset and enable us to get to work so aren’t these an investment?  These are true, but autos are a depreciating asset.  When you buy a new car, it immediately starts to depreciate and can lose as much as 40% of its value in the first 3 years.  So a new car buyer is paying interest on an asset that will lose value over time.

You can mitigate this buy saving up and paying cash for a car.  One technique for people who find it difficult to purchase their ideal car with cash is to work up to this over time: save what you can and purchase an inexpensive used car with what you can save in a year or so.  Purchase this car and continue saving.  If you would have paid $400 per month in a car payment, in just a year you can save close to $5000, enough to buy a passable used car.  Continue saving and when you have enough accumulated, sell the car you’ve been driving and trade up to a better used car that meets your needs.  Yes, you’ll have driven a beater for a year, but you’ll eventually own a good car, paid for in cash, that will not depreciate as quickly as a new car.  You’ll save in both interest and depreciation.

Labeling certain types of debt as “good” can give us a rationale to take out much more debt than we can handle.  Make sure that you plan and evaluate these debts carefully to ensure that they don’t become a future burden.

Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs.  DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.