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This article is part of our series about financial literacy. You can find the links to the other articles at the bottom of the article.
As discussed in our article, Dave Ramsey vs. Robert Kiyosaki, not all debt is bad. Debt plays a vital role in the economy. And on a personal level, if you take on reasonable amounts for smart reasons, your life will go much easier.
On the other hand, credit card debt and too much student loan or house debt can be crippling.
So what exactly is the difference between good debt and bad debt?
Is having debt good?
Debt permeates most aspects of people’s lives. According to a recent report, the total household debt rose to approximately $14.6 trillion in the last quarter of 2020.
Most people wish to live without debt and spend their money on fun activities or save for retirement. However, you might not achieve all your financial goals without borrowing.
Essentially, getting into debt is borrowing from your future, and it’s sometimes unavoidable. For instance, only a handful of people can purchase their home or get a college education without taking out loans.
According to financial experts, there are good debts and bad debts. The distinction between the two is how each of them affects your life.
Source: Robert Kiyosaki, via AZQuotes.com
Generally, good debt helps you grow your net worth today or in the future. An example is a loan that buys you an asset that appreciates or generates extra income for you.
Examples of good debt include:
- A mortgage to buy a rental property with positive cash flow
- A business acquisition loan to buy a profitable business
- A student loan for a good paying degree, such as medical school or to become an engineer
On the other hand, bad debt accumulates liabilities and depreciating assets. If taking on debt can’t boost your financial situation, you should reconsider it.
Still, debt meant to increase your financial worth can eventually become a problem if you cannot repay it.
We see from this financial statement example that you develop wealth by acquiring assets that increase your income. Using debt to purchase an asset can be a smart thing to do, if you go about it right.
Think of having a significant business loan, mortgage, and student loan debt at the same time. If too much of your income goes into debt repayment, you’ll have a strenuous financial future.
Below, we provide examples to differentiate between good debt vs. bad debt.
What Is Bad Debt?
Cars are depreciating assets. They go down in value over time, and they take money out of your pocket to operate.
A new one can depreciate by 20% within the first year and retain only 40% of its buying price after five years.
Yet, not many people can buy a decent automobile purely with their paycheck or savings. So while buying your first car with a loan may be necessary (because it helps you get to work, the grocery store, etc.), it’s generally a good idea to buy the cheapest car that meets your needs.
In the United States, most people need a car to function. But knowing that a car is a liability is important.
Shop for the lowest interest payments and put down the maximum down payment you can afford. Or better yet, save up enough money to buy the whole thing.
Credit cards almost always bring bad debt because they’re used to buy “doodads”.
Most consumers use them to pay for consumables like food, clothing, toys, household items, and even vacations. Such things neither appreciate nor increase your net worth.
Furthermore, credit card debt is expensive. According to a recent card rate report, the annual percentage rate (APR) for new credit cards was 16.15% at the end of April 2021.
Use your credit card wisely, to build your credit. Even so, you should always pay off all the debt by the due date to avoid additional charges.
Use your credit card only to build credit. Which means that you should keep your balances extremely low, and pay them off regularly so that interest doesn’t accumulate.
Nowadays, you actually have many options to build credit outside of credit cards. Check out our article on How to Build Credit Without a Credit Card.
A Mortgage for the House You Live in
Everyone wants to own a beautiful home. It’s especially nice when you want to settle down and start a family.
Even though homes generally go up in value, Robert Kiyosaki, author of Rich Dad, Poor Dad, insists that people not view their homes as assets.
He explains on his blog that, “Instead of putting money in your pocket, it takes money out of your pocket in the form of a mortgage, utility payments, taxes, maintenance, and more. That is the simple definition of a liability.”
The cash flow pattern of the house you live in typically looks like this:
It’s true that for most people, buying a home is better than renting. You don’t have a landlord who can raise your rent, and your home value goes up over time as you pay off the loan.
But most people go about it in the wrong way. They buy the biggest home that they can afford the monthly payment on and get a 30-year mortgage. This leaves little room for saving and investing.
Instead, pay a more modest home, which leaves money in your budget for investing.
Then, once you’ve acquired wealth and increased your income, you can afford a bigger home more comfortably.
Personal Loans for Discretionary Purchases
Never borrow money for discretionary purchases like a home entertainment system, jewelry, or to finance a vacation.
Understandably, you want personal items and fun, but applying for a loan for such expenses is not advisable. Save until you have enough cash flow to finance them.
High-interest short-term debts like title loans and payday loans can land you in big financial trouble. Some lenders use them to prey on people with severe economic challenges and charge them exorbitant interest rates and fees.
According to the Consumer Financial Protection Bureau, the charges for a two-week payday loan can be as high as an APR of 400 percent.
If you can’t meet the loan terms, you may have to take out another one, adding yourself more financial burden. There’s never a reason to take on these debts. Borrow from family or friends if you’re in a bad situation, or find some other recourse.
What Is Good Debt?
Rental Property Loans
For most people, the biggest inspiration to own rental property is to generate passive income and a climbing net worth. In other words, you create a recurring income stream with relatively little effort.
The cash flow pattern of a rental property looks like this:
Rental property is an ideal option for long-term wealth building.
Taking on debt to acquire real estate or houses with positive cash flow can be a wise financial decision, if you’re smart about it.
The key to smart rental investing is to have tenants that pay you more in rent than what your monthly expenses are.
And you should invest in a city or neighborhood that is growing, not shrinking, so that home values don’t go down over time.
Although I typically agree with Robert Kiyosaki that one’s home is not an asset, there are exceptions.
Some people buy a new home every couple years and always rent out the old one. This is called “house hacking”, and it can be a good way of getting into homes with a loan down payment.
There are a few ways to turn the home that you live in into an income-producing asset:
- Buy a multi-family home, like a duplex or a triplex. You can live in one unit and rent out the others.
- Use AirBNB to rent out your rooms or sections of your home to people on vacation. It takes a little more work, but a lot of people get great returns doing these short-term rentals.
- Don’t want to live with strangers? You can use sites like Neighbor to rent out parts of your home or garage for storage space.
- Start a home-based business. When you own your home, you can do things with it that you can’t in an apartment, like store construction tools or house inventory.
Here’s where I part with “Rich Dad, Poor Dad” philosophy. I do think that student loans can be a smart use of debt.
Also Read: Best Net Worth Tracker
Why? Because it enables people to raise their career opportunities and income potential.
People with a bachelor’s degree typically make $1 million more in their lives than employees with only a high school diploma.
And becoming a high-paying professional, such as a doctor, dentist, or engineer, can pay off quite nicely. People usually make $150,000+ per year in these careers.
However, you should study a course with high employment prospects and borrow meticulously. Student debt turns into a bad debt when you use it to pursue a degree that doesn’t have good job prospects.
Or, if you take too many years to complete college – the 7-year bachelor’s degree that could have been completed in 4 years.
Personally, I didn’t finish college, and I do quite well. There are many career paths that don’t require expensive schooling to get into, and I’m a fan of those careers. Examples include:
- Developers (programmers)
- IT professionals
- Professional salespeople
That last one may seem strange, but you can make a ton of money in a variety of career-level sales jobs, including tech sales. I know of jobs in tech sales that pay a $50,000-$60,000 starting salary with benefits and generous bonuses and commissions on top of that. Total compensation for decent performers (not even top) is usually $100,000+ per year.
But that still doesn’t change the fact that many of the traditional professions, which usually require student loan debt, can be a great option.
Small Business Loans
Starting a business and working for yourself is an excellent way to grow wealth and become financially secure. If you don’t have enough capital to launch or expand your business, consider taking out a business loan.
Small business loans are good debts when they open opportunities to increase your income.
It’s ideal if your business doesn’t have to take on any debt. But for 99% of businesses, smart cash flow management requires taking on debt at some point. Smart reasons for debt could include:
- Buying inventory
- Acquiring other businesses
- Hiring more employees to facilitate growth
I say “could include” because even in these circumstances, you have to be smart with the way that the debt is used. For example, you could spend money on advertising that doesn’t work, and then you’re out all of the cash that you borrowed, with nothing to show for it.
What I believe is that debt is an accelerator. It’s neither good nor bad. It simply gets you want what you want faster.
Are you irresponsible or foolish with your spending and financial habits? Debt will impoverish you faster.
Are you smart with your money and your business decisions? Do you take prudent risks? Then debt will accelerate your success.
How to Focus on Good Debt and Avoid Bad Debt
First, take care of your bad debt:
- Pay off credit card debt
- Pay off and avoid car debt
- Avoid unnecessary house and student loan debt
Good debt is investment debt. It’s used to acquire income-producing assets. These include:
- Getting an education for a high-paying career
- Buying rental real estate
- Acquiring businesses
- Growing profitable businesses
To continue learning about financial literacy, see the following articles in the series:
- Personal Income Statement
- How To Create A Personal Balance Sheet
- Is It Better to Put a Large Down Payment on a House
- Dave Ramsey vs. Robert Kiyosaki: Who Should You Listen To?
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I am a Certified Lending and Credit Specialist and first gained experience fixing my own credit. My own credit scores went from the 500s to the 800s in one year. I studied economics at The George Washington University and now have my own business working with financial technology companies. I manage my own investments and live in Salt Lake County, Utah with my wife and two kids.