What qualifies as good debt?

Money is supposed to enable us as humans to live good lives. We don’t live for money. We use money as a tool to live well. Good debt is any debt that enables you to live a better life without significant short- or long-term negative consequences. Good debt can help you to make important long-term purchases (such as a home) or even to make an investment, so long as the investment has a good chance of providing a profit.

In this modern world, it is nearly impossible to function without any debts on your name. Not many of us can afford to pay cash for a new home or for our children’s college education. But then, many of us also let debt get out of hand.

According to experts, your total monthly long-term debt payments (this would include your mortgage and debt on your credit cards) should not exceed 36 per cent of your gross monthly income. In fact, this is one factor that mortgage bankers would look at when assessing the creditworthiness of a potential borrower. Maintaining this credit sweet spot can be difficult because it can be too easy to spend more than you can afford. In fact, personal bankruptcies have hit record highs in recent years.

Avoiding debt is also not a solution because it would mean depleting your cash reserves that you can use for emergencies. The real test is to determine which debts make sense and which do not.

Not all debts are bad. There are also good debts. These are debts that include anything you need but could not afford to pay up front without drastically reducing cash reserves or liduidating all of your investments.

Financial experts also say that for a debt to be considered “good†, two elements will need to be satisfied:

1. The object of the debt should be able to last longer than the loan
2. Whatever is going to be financed should provide a positive leverage.

To illustrate, let’s look at a car loan. If you do decide to get a loan for a car and finance it for three to five years, it definitely meets the criteria of a good loan because your car will most probably last longer. However, if you decide to finance your car for ten years then it becomes a bad debt because the debt will now likely outlive the purchase.

If the reason you are buying a car is so that it can make the commute going to work easier and help you in a new home-based business, you are setting up then you are getting a positive leverage from your financing since you will potentially be able to more than cover the additional costs from your potentially higher earnings.

Another way to look at good debts is that they are debts that can build you wealth over the long run. A good example of this is a mortgage debt. Home values have increased at a good pace over the past few years. Borrowing in order to buy a home makes it a good debt because you are also building value.

Ultimately, acquiring wealth through debt is a good reason to be borrowing money.