As a young college student or post-grad, you may have accumulated credit card debt. I certainly did. However, somewhere in the process of “adulting” you may have realized that having lots of debt isn’t a good thing. You may have even heard investment gurus like Dave Ramsey preach that all debt is bad and insist that people do any and everything to rid themselves of the terrible “D-word” as fast as they can. This can be great advice in many circumstances, but some things aren’t so black and white.
If you’ve attempted to delve into the world of personal finance, you might have seen some investors adopt a more nuanced philosophy. They believe that there is “good debt” and “bad debt.” Let me explain.
What is “Bad Debt?”
Bad debt is usually consumer debt. It’s when you borrow money via a bank loan, credit card, or store financing to purchase things like cars, clothes, or electronics that lose value over time. Some people may even view some student loans as bad debt, especially if they have a substantial amount of loans that may take a long time to repay.
What makes it bad?
The things purchased with “consumer debt” usually depreciate or go down in value over time. Plus, the interest rate at which we borrowed the money to purchase these items is high. Because the item depreciates and the interest rate is high, you end up paying a lot more for these items than they are actually worth. Taking months or even years to over-pay for something that loses value is inefficient at best and a waste at worst. Plus, you exponentially delay your ability to build wealth since the money you spend making payments is money that isn’t going towards your investments or things that will build your net worth. Instead of earning 5-10% profit on your money inside of a retirement account or lucrative investment, you are instead paying an extra 5-10% on something that is now worth a lot less.
Pro Tip on Bad debt: Get rid of it. Since bad debt, causes us to overpay for things that decrease in value, we should get rid of it and stop accumulating more. We should work to pay off our car loans, credit cards, and other high-interest debt as quickly as we can.
What is “Good Debt?”
Good debt is usually “investment debt.” It’s when you borrow money via a bank loan or private loan to purchase things like real estate, businesses, or commodities that increase in value over time. Some people may even view some student loans as good debt if the degree they obtained with the student loans allows them to get a high-paying job they wouldn’t have gotten without the taking out loans.
What makes it good?
You were able to borrow the money at a low interest rate and purchase things that appreciate or go up in value over time. Getting a loan to purchase assets (things that increase in value) is considered good debt because you can theoretically sell the item, pay back the money you borrowed, and make a profit in return. In fact, this is one of the main ways people build wealth through real estate investing. Many investors borrow money to purchase a home (by taking out a mortgage) and use the tenant’s rent payment to pay off the mortgage over time. Some experienced real estate investors may even secure investment loans that allow them to purchase an entire apartment complex or commercial building. They work to increase the value of the building (by renovating it and raising the rents), then sell the building to another investor a few years later at price that allows them to pay back the money they borrowed and keep a large profit in return.
Pro Tip on Good Debt: Be cautious. While it may make financial sense to accumulate good debt to increase the number of assets you own, make sure you are in a financial position to do so. Having too much debt, good or bad, can put you at risk of defaulting on loans if unexpected events occur. Good debt is something to consider once all of the “bad debt” is gone and an investment opportunity you have studied extensively is presented.
My Point? Bad debt is bad because you borrow money at a high interest rate to purchase liabilities (that decrease in value over time) which can decrease your net worth. Good debt is good because you are able to borrow money at a low interest rate to purchase assets (that increase in value over time) which can increase your net worth. Get rid of bad debt, be cautious about good debt.