Should Know The Difference Between Good Debt and Bad Debt

Many popular personal finance gurus espouse a philosophy of avoiding debt at all cost. They point to all the negative consequences of abusing credit, with an overarching theme of how big, evil credit card companies and banks take advantage of ordinary people and drive them into a lifetime of modern-day slavery to their credit card debt.

But what they won’t tell you is that there’s actually such a thing as “good debt.”

Why Debt Can Be Good
Credit, used responsibly and in moderation, is good for the overall economy because it can help facilitate more transactions and allow for a faster transfer of goods and services. However, it can also be very bad for your financial health if abused. And abusing credit is extremely easy to do because money is constantly thrown at us by banks and other lenders.

The good news is there is a very easy way to determine if something is potentially good debt or bad debt. The key is to take a closer look at what debt really is—it’s simply spending your future income to buy something today. So it stands to reason that the only time you should borrow money against your future income is if you use it to buy something that will enhance your future income.

When you buy a latte using a credit card, for example, you’re borrowing from your future self’s income to buy that coffee today. You don’t have the cash to buy that coffee, so you charge it and go on your merry way. It’s your future self’s problem, right?

The problem with this is not, in and of itself, the fact that you bought something on credit. The problem is that what you bought on credit doesn’t increase your future income, which is what you will use to actually pay for that coffee. But if, on the other hand, you borrow money to buy something that will produce income in the future, then you’ll have the money to pay back the debt plus the interest. The key is to buy something that pays enough additional income (or that appreciates in value) to do that and still have more leftover.

For example, let’s assume you used credit to buy a rental property. That property receives income every month, right? Therefore, you’ve increased your future income by buying that property, even though you didn’t have the full amount in cash to buy it.

That is the fundamental difference between “good” debt and “bad” debt.

Examples of Good Debt
Here are a few examples of what I consider potentially good debt, if used responsibly. Now, you can probably find an exception to these broad categories. For example, while I list student loans as potentially a good debt because, in theory, it increases your future income, a degree in the humanities that costs $200,000 may not fit that mold. But generally speaking, student loans can be good debt if they help you build skills to compete in the job market and earn a good income. The key is considering whether the future payoff is enough to warrant the cost.

Student loans
Mortgages on rental property
Business loans (Again, like any debt, these can be easily abused. But if the business is successful then, obviously, using debt is a lot quicker way to get started.)
Credit cards – but only if you pay off your credit card in full every month, on time. If used this way, you can rack up tons of rewards and also build your credit.
Benefits of Good Debt
Some of the everyday benefits of using debt wisely include building a good credit score, getting perks and rewards such as airline miles and cash back, and tax advantages (on mortgage interest and student loans, for example.) But the most powerful benefit of credit is the concept of leverage. An in-depth discussion of leverage is beyond the scope of this article, but I’ll say here that leverage is just what it sounds like—it works like a lever to increase your investment return over what you could achieve with cash alone.

As an example, let’s assume that you buy a rental house for $100,000 and put down 20% for the down payment, so $20,000. This particular property rents for $1,000 per month, and your total expenses including mortgage interest, maintenance, taxes, and insurance are $800 per month So, you make $200 each month from this property, which is an annual return of 12% on your original cash investment.

Now let’s compare that to if you had not borrowed the 80% to buy the property, but instead paid for the whole thing with your own cash. In this case, you do not have to pay the mortgage payment, and therefore can “net” much more from each rent payment. Let’s assume you now get about $600 net each month in rent.

You’re making more money, right?

While you are making more in dollar terms, you actually earn less as a percentage of your initial investment. Believe it or not, your investment return has actually gone down. Why? Because the mortgage acts as a lever to increase your return. In this case, the un-leveraged rate of return would be 7.2% ($600 per month times 12, divided by your investment of $100,000.)

While Debt Can Increase Returns, It Also Increases Risk
Lest I give you an overly rosy picture about debt, let me add one more clarifying detail. In the above example, I showed how the return on a rental property can be almost doubled by adding leverage. While that is true, and a well-known financial principle, it should be noted that leverage works both on the up-side and the down. The recent financial crisis is a classic example of this. Many investment banks were highly leveraged with complex mortgage-based financial instruments, and when the economy turned, they went bankrupt or had to be bailed out. It works that way on a personal level too. Debt can be a powerful tool, both for good and for bad. If you decide to employ good debt, please use it responsibly and with caution.