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, up keep 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, up keep 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.
The Two Types of Debt You Need to Know!
There are really two sides to debt. In general debt is typically bad, but on the flip side, there is good debt. What is good debt? Good debt is money you borrow to pay for something that will increase in value and/or will pay you back after you make the purchase. An example of debt that’s good would be debt that pays for furthering your education, provided that the education produces income.
Another example, such as 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. As I hope you’re beginning to realize just from these couple of examples, is that debt is not always bad in certain circumstances if managed properly.
“Bad debt is sacrificing your future day needs for your present day desires.” – Suze Orman
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 produce an income.
As you can see, there is a difference between good debt and bad debt. Hopefully you understand the fine line that is between them in certain circumstances. The thing with good debt is that it has the potential at any point of becoming bad debt. But don’t be discouraged, because it’s that understanding that will improve your financial well-being and get you on the road to creating wealth.
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