For many of us today, debt is just a fact of life. It’s how we pay for just about everything from the homes we live in, to the cars we drive and even down to the small, day to day purchases like food, gas, that daily cup of coffee (or 3), etc. No matter how debt is used or what it is used for…simply put, debt is an amount of money borrowed by one party from another that needs to be paid back. Based on that explanation, debt may not sound good or bad. We need to understand that there are different types of debt and that not all debt is considered equal. The reality is that there is a difference between good debt and bad debt. Although there is some debate about what those differences are, the bottom line is this…good debt puts money in your “pockets”, where bad debt takes money out of your “pockets”! And there are many instances where there is a fine line between the two. Let’s take a closer look and hopefully shed some light on this subject.
Let’s start with bad debt. What is Bad Debt? Bad debt is usually obvious and sometimes it’s not. Let’s break it down…bad debt is money we borrow to pay for something that will not increase in value and/or not pay us back after we make the purchase. A clear cut, prime example is using a credit card to pay for that round of drinks just to impress friends. Another example would be a car loan. Vehicles lose more than 50% of their value within the first five years. Even taking out a mortgage to buy a primary residence can be considered bad debt! Until we’ve completely paid off our mortgage and sell the house for more than we paid for it, it’s bad debt. Even after the mortgage is paid, there is always maintenance, upkeep and property taxes…money coming out of our pockets, right? Although the price of real estate historically goes up (if we hold on to it long enough), hopefully we can sell it for more than we paid for it, including all the money spent during the years for maintenance, upkeep and property taxes. Now, I’m not saying don’t ever buy a house, but for the sake of understanding the difference between good debt and bad debt and the fine line between them, this is definitely food for thought.
On the flip side, we have good debt. What’s Good Debt? Good debt is money we borrow to pay for something that will increase in value and/or will pay us back after we make the purchase. Examples of debt that’s good would-be debt that pays for furthering our education. Going back to the example given above regarding a mortgage, financing an investment property is usually considered good debt as long as the rent payments are greater than all the expenses incurred, and it can be sold for more than the purchase price. Even financing a car can be considered good debt if its use will generate income greater than the expenses, as in a taxi or shuttle service. On that same note, borrowing money to start a business can also be considered good debt, providing the business at some point generates income to re-pay the debt and provide income. As we can see, there is a difference between good debt and bad debt, and hopefully we understand the fine line that is between them in certain circumstances. It’s that understanding that will improve our financial well-being and get us on the road to creating wealth.
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