Good Debt vs. Bad Debt
Okay, so debt generally stinks.
I think we’ve established that in the last lesson. But sometimes you’ll hear people talk about good debt versus bad debt. Is there really a difference, or is it just a scam?
What’s bad debt?
Where do I start? Actually, let’s just assume that all debt is bad debt, unless it’s good debt. Can we do that? So that means, unless the debt falls into the category of good debt, we can assume with a high degree of certainty it is bad debt and that it will ruin your life. Okay?
So, what then is good debt?
Remember we talked about assets? These are things that you own that have value, such as a car, new kitchen table, or mutual fund. We don’t want to use debt to buy just any assets. We would only consider using debt to buy appreciating assets. And no, an appreciating asset is not an asset you are thankful for. An appreciating asset is one that appreciates, which means it goes up in value.
So, let’s take a look at the examples from earlier.
Which one might go up in value over time?
• Kitchen table
• Mutual fund
Out of all three choices, the only answer is the mutual fund. If you’re strapped for cash, think twice before you purchase a new car or kitchen table.
The lesson here is that if you’re going to go into debt, make sure it is for an asset that will go up in value over time.
Ask yourself, “Am I buying something, or am I buying an investment?” If you’re not buying an investment, then do not buy it with debt.
What are a few examples of good debt?
- Buying a house and having a mortgage. Over time, houses generally go up in value. That’s a fair use of debt.
- Education could also be a good use of debt. Think about it. You are the asset in this case. If the education will help you get a designation, new degree, or new skills that will help you advance in your career and make more money, then you are the appreciating asset. But be careful here. Before you pull out your credit card, really think long and hard about what you are buying and if the class or education will really help you make more money. If not, it’s just an expense and it’s a bad use of debt.
- Borrowing to invest in a business could be good debt, but be very careful. Just because you want or hope an asset will go up in value doesn’t mean it will. Before you become a slave to debt, you must be sure whatever you are using the money to buy has a very good chance of going up in value. A business could go up, but many people have gotten themselves into trouble by borrowing too much, not seeing their business succeed, and then being stuck with a lifetime of bad debt dragging them down.
Want a quick rule of thumb when it comes to good debt and bad debt?
Just ask yourself, “Will I make money by buying this?” If the answer is “Yes,” it’s good debt. If the answer is “Maybe,” “I’m not sure,” or “No,” then it’s bad debt. Stay away!
But what should you do if you are already in debt? I’m so glad you asked!
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.