Good debt vs bad debt

Debt, for many people today, is simply a fact of life. It's the way they pay for just about everything from big-ticket items like homes and cars to daily purchases like petrol and chocolate bars.

At its most basic definition, debt is simply an amount of money borrowed by one party from another. Under this definition, debt sounds neither good nor bad. A closer look at the subject provides a more sophisticated way of both viewing indebtedness.

Good debt
There's no better example of the old adage "it takes money to make money" than good debt. Good debt helps you generate income and increases you net worth. Four notable examples of good debt include:

1. Technical or university education
Education has long been synonymous with success. In general, the more education an individual has, the greater the person's earning potential. Education also has a positive correlation with the ability to find employment opportunities.

Better educated workers are more likely to be employed in well paid jobs and tend to have an easier time finding new opportunities should the need arise. An investment in a technical or college degree is likely to pay for itself within just a few years of the newly educated worker entering the workforce.

Over the course of a lifetime, educated workers can rack up a return on investment measuring in the hundreds of thousands of pounds.

[Related feature: Are degrees still worth it?]

2. Small business ownership
Making money is the point of starting a business. Earning income is a primary benefit of entrepreneurship, with being your own boss also a positive result of the endeavour.

Not only can you avoid reliance on a third-party to hire you and give you a paycheque, but your earning potential can be directly improved by your willingness to work hard. With a bit of luck, you can turn your drive and ambition into a self-sustaining enterprise and perhaps down the line, an initial public offering (IPO) or sale to another business that results in serious money.

3. Property
There are several ways to make money from property. On the residential front, the simplest strategy often involves buying a house and living in it for a few decades before selling it for a profit. Residential property can also be used to generate income, by taking in a lodger or renting out the entire residence. Commercial property can also be an excellent source of cash flow and capital gains for investors.

4. Investing
Short-term investing provides an opportunity to generate income and long-term investing may be the best opportunity most people have to generate wealth. The wide variety of available investments – from traditional stocks and bonds to alternative investments, commodities, futures and precious metals (just to name a few) – provides an array of choices for just about every need and every risk tolerance.

[Related link: Are you overpaying? Compare mortgage deals online]

No guarantees
While good debt may seem like a great idea, it is important to realise that even the best ideas don't always work out as intended. A second look at those four "good debt" categories underscores the point.

The downside of higher education
In and of itself, an education is not a guaranteed ticket to wealth and success. A field of study must be chosen carefully, as not all degrees and qualifications offer equal opportunities in the marketplace.

Difficult economic conditions must also be taken into consideration, as lucrative career opportunities will be more difficult to find during economic downturns. Workers who are unwilling to relocate to areas where their skills are in demand or unwilling to accept low-paying, entry-level jobs may find their degrees don't deliver the expected returns.

The risks of small business ownership
Like any business venture, small businesses run the risk of failure. Hard work, a good business plan and a little bit of luck may all be necessary to help you fulfil the dream of working for yourself.

The property money pit
Until just a few years ago, buying property seemed like a guaranteed win for most homeowners, as price rises seemingly only went up. Downward fluctuations in global house prices have taught many homeowners that price rises are not guaranteed. On the other hand, home maintenance costs last forever.

Investing
Investing can be a complex and volatile process. Just as fortunes can be made, they can also be lost. Do-it-yourself investing isn't the right path for everyone and even hiring help doesn't guarantee a positive result.

[Related feature: The old rules of money have changed]

Bad debt
While "good debt" can have a downside, certain debts are downright bad. Items that fit into this category include all debts taken out to buy depreciating assets. In other words: "If it won't go up in value or generate income, you shouldn't go into debt to buy it." Some particularly notable items related to bad debt include:

1. Cars
Vehicles are expensive. New cars, in particular, cost a lot of money. While you may need a car to get yourself to work and to run the errands that make up everyday life, paying interest on a car is simply a waste of money. By the time you drive off the car forecourt, the vehicle is already worth less than it was when you bought it.

Put your ego aside and pay cash for a used car, if you can afford to do so. If you can't, buy the least expensive reliable vehicle you can find and pay it off as quickly as possible. Buyers who insist on living beyond their means and financing a new car should look for a loan with little to no interest on it.

While you'll still be spending a large amount of money for something that depreciates until it is worthless, at least you won't be paying interest on it.

2. Clothes, consumables and other goods and services
It's often said that clothes are worth less than half of what consumers pay to purchase them. If you look around a second hand clothes shop, you'll see that "half" is being generous. In addition to clothes, holidays, fast food, groceries and petrol, these are all items commonly bought with borrowed money. Every penny spent in interest on these items is money that could have been used more wisely elsewhere.

3. Credit cards
Credit cards are one of the worst forms of bad debt. The interest rates charged are often significantly higher than the rates on consumer loans and the payment schedules are arranged to maximise costs for the consumer. Keeping a balance on a credit card is rarely a good idea.

[Related link: Switch your debt to a top 0% balance transfer credit card]

The grey area
In between good debt and bad debt is a grey area that generates a lot of controversy. Three controversial topics in this area include:

1. Consolidation loans
For consumers who are already in debt, consolidating higher-interest debt by taking out a loan at a lower rate of interest is a great idea, in theory. In reality, it often just frees up cash flow that consumers use to fund new debt.

2. Borrowing to invest
Leveraging, or borrowing money at a low interest rate and investing at a higher rate of return, may appear to investors as a solid way to get better-than-expected results. Unfortunately, it comes with numerous risks for the inexperienced and the potential of losing a significant amount of money and being required to compensate your broker for the borrowed funds used in trading.

3. Credit card reward programmes
There are some great credit card reward programmes available for consumers. The money spent using credit cards can help buyers earn free airline tickets, free cruises, cashback and a host of other benefits. The danger here is that the interest spent on the credit card debt offsets the value of the rewards.

[Related link: The top rewards credit cards]

Conclusion
There is certainly an argument to be made that no debt is good debt. Unfortunately, few people can afford to pay cash for everything they purchase.

With that in mind, a motto of "everything in moderation" is the right approach to take where debt is concerned. Remember, even "good" debt has a downside.

More from Investopedia.com
5 ways your partner can ruin your credit
10 ways to budget when you're broke
Why you DON'T want to be a millionaire