People have been debating for years whether there is something called ‘Good debt’ and ‘Bad Debt.’
A lot of people will tell you that all debt is bad and that you shouldn’t use it.
Others will tell you that debt (sometimes called leverage), when used correctly, is good.
The difference between good debt and bad debt is how you use it. It depends on whether or not you can make smart financial decisions using debt.
Smart financial decisions are the key to becoming wealthy and obtaining financial security, whether debt is used or whether it is not.
Debt is debt, there isn’t really any good or bad
Let’s be clear, there are a lot of people that have become very rich using debt.
Donald Trump has mentioned that he likes using other people’s money (regardless of what people believe his net worth is, he’s rich).
Well, that means that he likes using debt. That’s what happens when you use other people’s money – you go into debt.
Robert Kiyosaki, the author Rich Dad Poor Dad, has often boasted that he likes using debt to purchase real estate. Kiyosaki likes to purchase undervalued real estate using the bank’s money. His investment strategy has been to find properties that he knows he can rent successfully – this way he can live off the passive income it creates.
Both Donald Trump and Robert Kiyosaki have become very wealthy by using debt.
However, for every Trump and Kiyosaki, there are probably 1,000 people that have become poor using debt.
The key questions to ask when considering to use debt are:
What is the debt being used for?
Can using the debt allow me to make money in the future?
You’ve probably heard that credit cards are bad.
While I won’t argue that the high-interest rate applied on most credit cards is not good, it really depends on how you use credit cards.
If you have to put car repairs on your credit card (because you do not have an emergency fund or have no other option) so that you can get to work that’s a good use of debt.
You’re using it to make sure that you can still make income.
If you buy new rims, hydraulics, or a stereo system using your credit card that’s probably not a good use of debt.
I like to use my credit card to receive reward points and discounts on other purchases. However, I make sure I pay off the balance at the end of the month so that I am not charged interest.
When people say that they don’t like debt, what they probably really mean is that they don’t like paying interest. It’s the ongoing payment of interest that will keep you in the poor house while it makes someone else rich.
Using loans when it does not create value is not a good use of debt.
However, using loans where you create value can be a good use of debt.
Use debt like a business owner
Think about how businesses use credit.
A big reason why companies use credit is that they expect to generate long-term value.
A company takes out $5 million in loans because they hope that they’ll be able to create more than $5 million in value over the long term.
A company sees a way that it can make more money or save some money by spending less.
It doesn’t have cash just sitting around to take advantage of the opportunity so it has to take out a form of capital (equity, debt, etc.) to accomplish their goal.
A business uses loans and takes out credit to grow the company with the hope that it will produce more revenues, maybe reduce costs and generate more net income.
You should think about credit the same way.
How can you use your ability to access credit to make more money or increase your net worth?
Maybe that means taking out student loans so that you can learn new skills and get a better paying job. If you know that you want to become a doctor, then taking out a student loan to finance your education is probably worth it.
Special Note: Be careful with student loans. See my previous post on how student loan debt is killing the American dream.
Maybe it’s taking out a mortgage to buy a house that you’ll turn into a rental property later in life.
The lesson to learn here is that debt is neither good or bad. It’s how the debt is used that will determine whether it is beneficial in the long run.
With debt, making smart financial decisions means understanding how loans and other forms of credit work, and knowing your motivations for using it.
The Value Created Doesn’t Need to be Money
Smartly using debt does not always have to result in making money or increasing your net worth.
Sometimes debt creates non-monetary value in your life like a mortgage for your own home.
Your life is not a business.
Maybe, buying a house will provide you a sense of accomplishment and you won’t have to deal with all the negatives of renting.
You may need to take out a mortgage to pay for a house though.
There’s a chance that the home doesn’t appreciate and you end up spending more than renting because of repairs and taxes but you’ve still created a form of value.
This can quickly go into a grey area though.
Maybe buying some new clothes boosts your confidence which does create some value.
Is this example a good use of debt?
It’s hard to tell, hence the grey area.
But, in this specific example, we would guess that the value created is shorter-term with the good feelings associated with an outfit wearing off.
Do these good feelings outlast the amount of time it takes you to pay down the debt?
Creating long-term value with debt
When you’re deciding whether to use a form of credit ask yourself:
Does using this debt improve long-term value for my life?
The difference between you and a business in this situation is that a business focuses on profit and you’re just trying to live your best life.
That’s why it’s okay to use debt for things that may not necessarily create additional money but makes your life better.
You just want to balance this potential grey area the knowledge that debt can make your life worse if you use it on the wrong things.
Another question to ask yourself:
Will using debt cause a more negative effect on life than the positive value the purchase is generating?