Good Vs Bad Debt: When To Borrow, Pass, Or Pay Cash

Forbes

4 days ago

Figuring out when to take out a loan, pay cash, use leverage, or pass when something isn't ... More affordable. Unpacking good vs bad debt.
Myth: you should always pay cash if you can. Fact: investors should strive to have multiple tools in their financial toolbox, including taking on debt, using leverage, paying cash, or knowing when to pass when something isn't affordable or just doesn't make sense financially.
Yet, it can be difficult to figure out when to use one over the other. Other common challenges include overcoming the mental hurdle of taking on debt even when it's advantageous and respecting potential gaps between what someone is willing to lend and what you can truly afford to borrow. Remember: all debt is bad debt if you can't afford it.
Typical Examples Of Good Debt Vs. Bad Debt
It is worth noting that the definition of good versus bad debt isn't exact. As with anything in personal finance, here too the answer is 'it depends'.
For example, at face value, taking out a mortgage to build equity in a home or using student loans to advance your education and increase your earning potential are positive financial steps. But as illustrated in 2008, there are risks to consider before buying a home with an adjustable-rate mortgage (ARM).
And although investing in education has the potential to pay off, it isn't always worth it, so consider the economic value of the chosen major, salary ranges and financial trajectories given likely career paths.
Borrowing: Considerations For Debt
Here are some of the initial factors you'll need to consider when determining whether it's advantageous to take out a loan.
Mortgages
Getting a mortgage can provide tax benefits for taxpayers who itemize their deductions. Generally, when buying a primary or second home, interest on loans up to $750,000 can be deducted. This includes home equity lines of credit (HELOCs) if the proceeds are used to buy, build, or substantially improve the residence.
Given the increase in the standard deduction, made permanent in The "One Big Beautiful Bill Act" (OBBB), and changes to state and local tax (SALT) deduction caps through 2029, you'll want to run the mortgage interest math. For some, it will be essential for itemizing, for others, it still won't meet the hurdle.
If you don't have the cash on hand to purchase the property outright, the primary issue is affordability. In addition to the debt consideration list above, consider the extent to which the purchase will reduce your financial flexibility and ability to manage unexpected costs or events. Remember, lenders typically calculate how much you can 'afford' to borrow using minimum payment requirements. This often isn't truly representative of your financial obligations or prudent measures you're already taking, like paying off credit cards in full each month.
If you are able to buy a home with cash instead of a mortgage, consider the opportunity cost. When interest rates are low, it can be a missed investment opportunity if you think your portfolio would produce greater returns than the interest rate on the loan. When rates are higher, it may make more sense to buy with cash, and leave the door open to doing a cash-out refinance if rates drop. If an investor's cost of borrowing is less than their expected rate of return, that's an opportunity for leverage.
Student Loans
The truth is, college is expensive. As a purely financial decision, the investment doesn't always make sense. Parents are encouraged to help their kids with this important exercise to avoid taking on loan debt that cannot easily be repaid. From a debt perspective, pre-planning is essential.
The rules around student loans are complex, and many students will have different structures. This can include multiple tranches of loans (to align with each academic year), subsidized and unsubsidized loans, family loans or parent PLUS loans, federal and private loans, or other borrowing arrangements. This can make it difficult for students to grasp what they'll owe after graduation.
Ideally, students can keep borrowing costs low by working part-time, comparing the total cost of one school versus another, and spending the time investigating and applying for merit scholarships. If you do take on debt or if you're considering consolidating or refinancing, understand the differences between federal and private student loans, such as forbearance, income-based payment options, and forgiveness.
As with any financial decision, the best choice is an informed one. From a tax standpoint, the student loan interest deduction isn't much of a game-changer. The maximum amount of interest that can be deducted annually is $2,500 (for single or married taxpayers filing jointly). The deduction begins to phase out for single filers when their income exceeds $85,000 or $170,000 for married filers in 2025.
Auto Loans
Car loans are getting a lot of attention these days thanks to the OBBB. Under the new tax law, individual taxpayers may be eligible to deduct up to $10,000 per year in interest paid on auto loans for personal-use vehicles. There are rules and requirements to be aware of though, including income limits, which disallow single taxpayers earning more than $100,000 annually ($200,000 for couples).
This new interest deduction is a perfect example to illustrate the difference between 'can' and 'should'. Let's look at the math:
According to NerdWallet, the average interest rate for new car buyers with Prime credit scores (661-780) is currently 6.70%. Assuming a five-year loan, a borrower would need to spend more than $160,000 on a new car to maximize their interest deduction in the first year of the loan. Given the income limits to qualify for the tax break, this would never make financial sense.
Car loans are often considered a grey area as far as good versus bad debt is concerned. Consider overall affordability, whether there's a need to build credit, and what other options you have. Cars are means of transportation, not investments. Buyers should remember they can get upside down on their car loan, which can be particularly painful after an accident or serious mechanical issue.
Credit Cards And Buy Now Pay Later
When used responsibly, credit cards have little downside: earn rewards or cash back for purchases, 30-day interest-free loan when paid off monthly, help settling disputes with vendors, opportunity to build credit, and other services. Credit cards are also an excellent way to safeguard your finances, due to the enhanced fraud protections. This fact alone typically makes using a credit card a better option versus paying with cash using a debit card.
However, spenders often get into trouble quickly when they can't pay off their balance every month. With average interest rates around 25%, it is easy to get into a deep hole. This is when credit cards go from good debt to bad debt.
Buy now, pay later (BNPL) programs are a relatively new way to pay. Some programs offer no interest installment payments and flexible payment plans. This can help with timing issues (like waiting for a bonus check for example). BNPL programs might not check your credit, which can be a plus as hard inquiries impact your credit score. However, these installment payments can make it difficult to track what you owe and can lead to overspending.
Starting fall 2025, FICO scores will include data from buy now, pay later loans. This will help some borrowers build their credit, and hurt those who overextend.
There are no tax benefits for interest paid on either payment method. As with any form of debt financing, just because someone is willing to lend it to you, doesn't mean you can afford it. Using credit cards or BNPL programs can be a good way to optimize payments versus cash, but neither should be considered a substitute for having the cash today. So typically, if you don't have the cash in your bank, you should consider passing on the purchase altogether.
Borrowing Against Your Portfolio
A securities-backed line of credit is like a home equity line of credit in many ways, except the collateral is your investment account, not a home. A securities-backed line of credit (SBLOC) allows investors to get cash by borrowing against their brokerage account instead of liquidating their portfolio to raise cash. It's a great example of using leverage, too.
Although it likely is not a good long-term strategy for most investors, it can be a compelling short-term solution while awaiting liquidity from other sources, such as the planned sale of a business. It can also be a top choice for homeowners looking to buy a new home before selling their old one.
The main benefits of using a portfolio-based loan are: avoiding capital gains tax from the sale of investments and because there isn't a sale, the account stays fully invested. This helps borrowers avoid the opportunity cost of using cash or investment assets. These types of loans typically avoid the usual fees of a mortgage or other type of secured loan. The interest you pay on the loan may also be tax-deductible depending on what the proceeds are used for. Investors may also have more flexible repayment options.
But borrowing against your portfolio carries risks. The lender may be able to demand payment at any time depending on the value of your account or other factors. If you own highly volatile assets, it will increase your risk and impact eligibility.
Again, in most cases, borrowing against an investment account should be considered as an optimization strategy or near-term solution for cash-timing issues, not a substitute for affordability issues.
Borrow, Pass Or Pay Cash
To summarize: if a purchase is going to put undue pressure on your financial situation or is otherwise out of reach financially, consider passing. That doesn't mean not buying anything, though, but reconsidering the budgetary limits. When considering taking on debt versus paying cash, look at all the factors, like the cost of the loan, possible tax benefits, and opportunity cost for cash purchases.
This article is a refreshed version of my 2019 article on Good Debt vs. Bad Debt.