I learned the concept of “good debt” after I had just worked really hard to pay off all of my debt, so naturally, I was reluctant. I started small and still am very conservative when it comes to any kind of good debt. You don’t want to be over leveraged in any way, shape, or form, but using good debt as leverage in moderation can be a really powerful wealth-building tool.
For most Americans, bad debt is a standard part of life. Household debt has reached $17.69 trillion, a large chunk of which is credit card debt and auto loans. Bad debt is something that you consume quickly or that depreciates. Borrowing to support ongoing living expenses is not a good use of debt.
On the other hand, good debt is a powerful tool that can be used to invest in something that could increase in value or expand your income potential, offering a promising path to financial growth.
Simply put, good debt is invested in assets. Bad debt is used for liabilities.
Let me explain.
*Source: Investopedia
Using good debt as financial leverage:
Financial leverage is when you use borrowed money to amplify returns on an investment potentially. To break it down, let’s say that you have $100 to invest and earn a 10% return; now you have $110. Whereas if you invest $50 of your own money and borrow $50, the same $10 return would be a 20% return on your money minus the money paid to borrow the $50. However, it’s important to note that using leverage also increases the potential for losses, especially if the investment doesn’t perform as expected. If the interest on the loan is less than 10%, your net rate of return will be higher using leverage.
A few examples of good debt student loans, mortgages, and business loans are just a few examples of good debt. Other examples include borrowing to invest in a business or real estate, or to fund education or training that can increase your earning potential.
- Business Loans: If you want to purchase, start, or expand your business, you may consider getting an SBA (small business association) loan. These loans can be used for a variety of purposes, including working capital, real estate, and equipment. Be sure to do your due diligence before taking out a loan, though. You want to make sure the cash flow from the business is enough to cover the debt payment and the expenses of the business, including paying yourself.
- Mortgages: Buying real estate can be a good idea for wealth-building. You can put down a down payment on an investment property and take out a fixed-rate 30-year mortgage for the remaining balance. You can then rent the property to cover the mortgage payment, interest, taxes, insurance, and maintenance and still put money in your pocket every month (cash flow). The property value and rental rates (LINK) will increase over time. Plus, you can take advantage of the property’s depreciation and tax advantages.
- Student loans: If you’re looking at a career path that requires a four-year degree, you may want or need to take out student loans to help you achieve your goals. Once you graduate, you will enter the job market and have higher earning potential. Use your income to pay off your student loans. A general rule is that you don’t want to borrow more than you expect to earn as your starting salary. You can see what your anticipated starting salary maybe by going to Glass Door and using their salary comparison tool.
It’s important to note that good debt almost always has competitive interest rates and may offer longer repayment schedules.
It’s crucial to be conservative and not borrow more than you need or can quickly repay, fostering a sense of caution and responsibility in your financial decisions.
What is Bad Debt?
Taking out a loan to purchase a shiny new wristwatch, going on a vacation, or buying home goods are all examples of bad debt. And if you think people don’t take loans to spend extravagantly, consider that 1/3rd of American adults do that to fuel their holiday shopping spree.
It becomes even worse when paybacks have high interest rates. Any debt with high interest rates can be harmful, even if you take it for an essential purchase.
Examples of Bad Debt
- Credit card debt: Credit cards usually have very high interest rates, so carrying this balance can be deemed bad debt.
- Auto loans: Vehicles are depreciating assets, which means that they lose value every year until they are eventually worthless.
- High-interest Loans: Any loan with an unusually high interest rate is bad debt, regardless of what it funds.
- Debt for Unproductive Spending: Paying for a smartphone you don’t need, getting a wristwatch you know you cannot afford – all of this discretionary spending is bad debt.
Before discussing paying off debt, we should address the fact that you might be confused about prioritizing debt and investment. Our detailed guide, Debt vs. Investing: Which should you tackle first, has you covered.
Real Life Example:
I wanted to give a real-life example of how I used good debt. In 2013, my husband and I purchased a Victorian home in Baker that needed a lot of work. We fixed it up and gained significant sweat equity in the property. In 2016, we took out a $250,000 HELOC using the equity in our home. We used that money to build an ADU (accessory dwelling unit) behind our house in Denver. We furnished the unit and rented it on Airbnb. Given the location, price point, and amenities, it was rented nearly every night of the month. We then used that money to pay off the HELOC. We still own the property and have since rented both the main Victorian home and the ADU unit to long-term renters (we couldn’t Airbnb the ADU anymore because it wasn’t our primary residence). The total rental from both units is $6,300. The mortgage payment is $3,200, so even after all the expenses, this property still has a monthly positive cash flow. We have a fixed interest rate for the remainder of our 30-year loan, so the cash flow will also increase as we increase the rent. Plus, the home is now worth more than what we bought, so if/when we ever decided to sell it, we would have significant proceeds.
Hopefully, this will help you understand the difference between good debt and debt and how to use it to your advantage!
Questions? Let’s chat! I’d love to hear about your experiences with good and bad debt, or answer any questions you might have.
