Let’s get something straight: not all debt is created equal. There is good debt, which gives you an opportunity to make money and there is bad debt, which you continue to dump money into with no expectation for return. While the differences can be subtle, anybody trying to become more financially literate must know the fundamentals behind good debt vs bad debt.
When talking about personal finance, particularly when the topic of budgeting comes up, all you hear about is debt, debt, debt. Like most Americans, you begin to wonder what to do because everyone in America it seems carries debt and everything “worth having” requires you to go into debt.
This is the how the story typically goes. You go into debt to get an education. Then, you go into debt to get married. Next, you buy a house and take on a huge mortgage.
This is when I borrow money to make more money.
For example, I borrow money and buy an investment home. I call this home an investment because I rent it out. Each month, my tenant pays my mortgage, taxes, and insurance in the form of rental income. My borrowed money gets paid back without me. Each month, I begin to gather equity in the home and, if I made a good investment, a little extra cash in my bank account.
Good debt could also be that I need to purchase a refrigerator for my house. In today’s market, I go to Sears and buy my refrigerator with no money down and 1-year free financing. I have the cash to pay it off in the bank (Note: I HAVE the cash).
However, instead of giving it up and saving for two months to pay myself back, I make 1% in interest which helps replenish what I am spending. If I am really smart, I have the cash in dividend paying stocks and my quarterly dividend pays for the refrigerator and I never have to touch the principal.
This is good debt: leveraging my money to work for me. Not once though did I overleverage. I did not borrow what I didn’t have and what I couldn’t pay. Each item paid for itself or was paid for through an investment without costing me my actual cash.
Look at this way. This is an approach to life. It’s not just a personal finance lesson or a chance to increase your financial literacy. Forget the buzz words.
This is a lifestyle. Don’t buy what you can’t afford. It requires discipline and a change in thinking. You need to come at this like you would if were learning anything else.
Be open to cultivating a growth mindset with regard to debt. What do I mean? I mean you need to change your thinking.
What is Bad Debt?
This is borrowing money for items that you can’t afford. These items lose value over time and do not provide me with an income in return.
Often, the debt can outlast the value of the item. For example, consider a car. My car is worth less than my loan when I drive it home. This is bad debt. If I had to sell it tomorrow, I would owe more than I have. While my car provides a service, it is not producing me a return on my money.
If I can pay for my car in cash, but chose not to because I take interest-free financing — this now is good debt. I can pay for the item, but chose to allow my money to grow free of charge.
The key to growing wealth is being able to make decisions, plan for the future, and be in a position that your money is always working for you. Buying a $20,000 car, taking out a full loan, having no cash, and driving it until it is worthless does not help grow my wealth.
Instead, I should have created an opportunity that will pay for my car without having to do so myself. Really it’s about making my money work for me.
In terms of a home, this like all other things, can go both ways. If I buy the most expensive house in the worst neighborhood, do no work, and let it fall down around me, I will lose money.
On the other hand, I could buy a house and acquire skills to make it a better house. Doing this will increase its value. Then, I can sell it, take the profits, and do it again if I want.
Now my profit is working for me, while I keep a roof over my head. Soon I will have wealth, while others still have debt.
Can you appreciate the differences between good debt vs bad debt?
It might appear subtle at first, but it becomes apparent the more you look at it. With good debt, I have the money or I’m bringing in the money to pay for it. I end up better off in the long-term.
With bad debt, I’m continuing to pay for it as it loses value. Not a winning situation. However, this is how most people use debt. It’s a tool that we allow to “screw” us.
Now you know the differences between good debt vs bad debt … so what will you do with this financial knowledge?
OK, you learned something (or were reminded of something) here with the differences between good debt vs bad debt. The question is now: what are you going to do with it? My suggestion is read as many books as you can, listen to podcasts, find courses you can take online or in-person, and do your own research.
There’s a lot to be said for teaching yourself something. You can make mistakes and fail, but those who learn from those mistakes and failures are winners because they choose to educate themselves.
So, be a winner. Be the person that goes above and beyond. Take this new knowledge and apply it to your life immediately. Tell people what you’ve learned and pass it on.
You will be doing your wallet and peace of mind a great service.
Did you know about the differences between good debt vs bad debt already? How have the two types of debt impacted your life? What is something you plan on doing as a result of reading this article? Share your comments and thoughts below.