When trying to figure out the difference between good debt and bad debt, I think it’s important to first ask yourself what does the actual word debt mean to you?
The obvious answer is owing money to someone else. Knowing this, if you asked most people if they like owing someone money, I’m guessing the majority of people would say no.
But to be honest, I don’t think the answer is so simple. Depending on who you ask, you can get a variety of different answers.
If you ask someone like Dave Ramsey, he will tell you that all debt is bad and that you should avoid it if you can.
But if you ask someone like Grant Cardone, he would tell you that debt is the best way to build wealth.
Both are very wealthy individuals, but have totally different views on debt. So in this article I will be going over what makes debt either good or bad.
By the end of this article, you should have a better idea of how debt can impact your life either negatively or positively.
Acquiring Debt Through Consumption
What gets most people in trouble when it comes to debt is when it is incurred due to consumption. We all like to buy nice things, and there’s nothing wrong with that as long as it’s done responsibly.
For example, if you’re using cash to make purchases on the things you want like vacations, cars, clothes, and other consumer items, then you’re less likely to get into debt because you’re using the actual cash you have available.
But what most people do is borrow money from financial institutions like banks that tend to carry very high interest rates.
This causes you to spend more of your future income paying back all the debt and interest you owe on that borrowed money.
Thus causing you to have less money for future goals. Now am I saying never borrow money to get the things you want?
No. But what I am saying is you need to be responsible and strategic with how you use borrowed money.
Basically, if you’re going to acquire debt, make sure it will provide a financial benefit to you.
For example, taking out a loan to purchase real estate is a form of good debt because of all the ways you can make money from it.
One of those ways is through rent if it is a rental property. How I like to look at it is, if the debt is making you money, it’s good debt.
However, if it’s taking money from your pocket, then it’s most likely bad debt (more on this in the next paragraph).
Good Vs Bad Debt?
The way I like to look at debt when determining if it is good or bad, is by looking at what it is doing to my wallet.
If the debt is putting money in my pocket, then it is most certainly a good debt. But if it is taking money out of my pocket, then I consider it bad debt.
Items that tend to be considered good debt and put money into your pocket are:
- Real Estate
- Education (It depends)
Real Estate - Some would argue that not all debt on real estate is considered good debt.
For instance, if you live in the home you purchased, based on the fact that it is taking money out of your pocket and not in, makes it a bad debt.
Now depending on your financial goals, this could most certainly be the case.
Yes there is opportunity for the property to increase in value each year you own it, but you don’t receive these gains unless you sell.
So depending on your financial goals, this could be considered either bad or good debt.
Business - To be honest, I’m not a big fan of starting a business with debt due to the fact that it’s rare that money is made right away.
But if you look at businesses that are already established, many of them tend to have debt on the books. But if the business is making a profit each year, then this would be considered good debt.
My advice would be to start your business with the least amount of debt as possible and scale it before you start taking on any serious debt.
Education - When it comes to education, I like to be a bit more specific on the type of education people are choosing to participate in.
That’s because if you haven’t noticed, we have a huge student debt crisis in the United States.
A lot of that has to do with people not really understanding what kind of ROI their degree will get them after they graduate.
Most degrees out there are useless but the debt levels are in the 10’s of thousand.
But assuming you are getting the right education and not going into significant debt to do it, this can be considered good debt.
Items that tend to be considered bad debt and take money out of your pocket are:
- Credit Cards
- Auto Loans
Credit Cards - When used correctly, credit cards can be a very useful tool. But many people with poor habits use credit improperly.
When using credit cards, you should never buy anything you wouldn’t be able to afford to pay in full every month when the bill comes each month.
That’s because you are paying interest on the balance you fail to pay off every month.
This is a horrible way to manage money because the interest rates can range anywhere from 15 to 24 percent. We can all agree that’s just a waste of money.
Auto Loans - If possible, I would recommend purchasing a vehicle in cash. That’s because once you drive the car off the lot, the value of the vehicle drops immediately.
When it comes to the interest rates, it all depends on the type of credit you have.
A good score will get you a good rate, but a bad score can really have you paying too much money for a depreciating asset.
Should You Be Using Credit Cards?
As I mentioned earlier, credit cards can be a very useful tool if used correctly. That’s because they offer so many benefits.
The fact that you can use the bank's money and not have to pay until the bill is due (which typically is up to a month later), is a huge benefit.
Other benefits of using a credit card are:
- Frequent flyer miles
- Cash back
- Fraud protection
However, using a credit card comes with a ton of responsibility.
If you are someone that struggles with making on time payments, then I would recommend that you stick with cash or a debit card.
This is also the case if you’re someone that tends to spend more than they make.
By using cash or debit, this will save you from digging yourself into a hole that can be very hard to climb out of.
Trust me I know first hand having accumulated 30k of credit card debt twice in my life.
Now that is no longer the case, and I make sure to pay off my balance each month to avoid paying any interest.