You may have never thought that the words good and debt could be used in the same sentence. However, there is a such thing as good debt.
But beware, all money that’s borrowed from a creditor has to be managed, or things can go south. According to the Federal Reserve Bureau, consumer debt grew to a record $4.19 trillion in December 2019. Those numbers are staggering.
If you’re going to achieve financial freedom, then understanding good debt is one of the lessons that you’ll need to master. As the wealthy know, it’s nearly always the tool used to achieve rapid accumulation of wealth.
Good Debt vs. Bad Debt: The Breakdown
Thankfully, there is a simple way to decipher between good debt and bad debt, which is: Bad debt will nearly always hurt your net worth, while good debt will nearly always grow it.
The vast majority of the time, good vs. bad debt boils down to these factors.
1. Bad debt has to be paid by you (for example, your credit card debt).
2. Bad debt comes from borrowing money to purchase depreciating items.
3. Bad debt often (although not always) has high interest rates that make it difficult to pay off.
1. Good debt is debt that is paid down by other people (for example, a mortgage that is paid down by your tenants).
2. Good debt is used to purchase appreciating assets that create income or net worth gains in excess of the cost of the debt.
3. Good debt makes you money. You can do this either by keeping the “spread” (the difference between the cost of the debt and the income you can produce from it) or by using it to increase your income.
For example, student loan debt may position you to secure a high paying job or taking out an auto loan for a work truck may allow you to scale your landscaping business. In both examples, you are using debt to drive new income.
However, there’s a bit of a caveat. Whether something is good debt vs. bad debt may depend on your financial situation. For instance, if you bought a property with expensive monthly mortgage payments that you were leasing out as a short-term rental (on AirBnB, for example), it could have become bad debt when the COVID pandemic hit.
Examples of Good Debt
Is debt a good thing? It certainly can be. Here are a few examples:
Buying real estate is usually a smart investment. You borrow money from a bank in the form of a mortgage at a low interest rate. Over time, the property will usually increase in value, the debt will get paid down, and you will benefit from numerous tax advantages.
If you use it as a rental property instead of a primary residence, you could also collect cash flow in the form of rental payments.
Not only that, but you could also make a profit when you sell it in the future.
Student loans get a bad rap nowadays. This is understandable, because lots of former students have exorbinant amounts of student loan debt. When student loan debt goes into default, it can ruin credit and can cause wage garnishment.
On the other hand, student loans can, in some instaces, be good debt. When you invest in your education, you invest in your future. Let’s say you take out a $20,000 loan for college.
If having a degree means you earn substantially more over your lifetime, then it could be worth it. By going into a profession that pays well, you earn back the money for the loan, plus more.
A business loan is usually considered good debt because of its purpose. You borrow money in hopes of gaining a profit. Launching a successful business could bring in thousands or even millions of dollars in revenue.
Let’s say you take out a $15,000 loan and in two years your company brings in $500,000 in sales. That’s what you call good debt!
Examples of Bad Debt
As you can see, good debt can potentially change your life for the better. But it’s the bad debt you have to worry about. Here are a few examples of it:
You might be wondering how buying a car is a bad thing. It’s a necessity, right? Yes. You need a car to get around and to commute to work.
However, in the grand scheme of things, buying a car is usually bad debt, especially an expensive car. The value of a vehicle depreciates as soon as you pull off the lot.
What’s worse, you pay interest on an item that won’t be worth much in a few years. Financing a car takes years, and usually by the time you pay it off, it’s time for a new one.
Credit cards are tricky. If you’re not careful, you can create a mountain of debt in no time. The problem with credit cards is that unless you pay off your bill in full each month, you will pay back way more money than the item was worth.
Purchasing clothes, gas, and movie tickets on a credit card isn’t wise unless you can pay off your bill in full each month. A credit card comes in handy when there’s an emergency, but not for frivolous spending.
Not to mention, if you pay your bill late the late fees add to the overall price of what you spent.
Pay Day Loans
Pay day loans are alluring when you need money, but the aftermath is terrible. A $500 loan can easily turn into $1,200 repayment if you’re not careful. Personal loan companies are in the business of making a profit.
Therefore, they’ll charge you double the amount that you borrowed. If you can, avoid them at all costs. It’s better to get the money from a family member or friend.
Only use them as a last resort and when you know you can pay them back quickly.
Believe it or not, there are some bad deb scenarios that might not be so terrible after all. Of course, they’re risky, but they might work for you. Take a look below:
1. Reward Credit Cards
Some credit cards offer good rewards like cashback and points. If managed properly, these types of credit cards can be advantageous. Receiving money back on everyday purchases is smart and gives you more bang for your buck.
Also, receiving rewards like flight points could also be a benefit. Just read the fine print of the card details before applying for it.
2. Consolidated Loans
If you’re already drowning in debt, a consolidated loan could help. It allows you to borrow money to pay off your bills at a lower interest rate.
Sure, it’s a “debt”, but it’ll help you save money over time.
3. Investment Loans
Borrowing money at a low-interest rate and investing it at a higher rate is smart, but risky. Many experienced investors use this trick all the time. Although the return could be great, there’s potential to lose money and still have to pay back the lender.
Final Thoughts: Good Debt vs. Bad Debt
Now that you know the difference between good debt and bad debt, you can make better financial decisions. When it comes to progressing forward, you may have to borrow money to jump-start your dream, and that’s okay. Accumulating good debt could be the start of a bright future for you!
It will teach you what you should’ve learned in school, like how to acquire rental real estate, negotiate a raise, invest for cash flow and so much more!