Understanding the difference between Good and Bad Debt

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Good Debt vs Bad Debt

 

Hopefully you’ve heard of good and bad debt before. If you look at the table below I’ve listed the different types of good and bad debt to give you an idea. This list isn’t all-inclusive but should give you a decent idea.

Good Debt and Bad Debt List

Good Debt Types

Let’s first look at the types of good debt. Good debt typically has some sort of immediate of future benefit. Although I categorized all of these as good debt, I’ll talk about the negative portions of each as well.

Good Debt: Mortgage – The Pros

There is a split opinion about mortgages because some people see a mortgage (or home ownership) as a liability and others see it as an asset. Technically, having a mortgage is both since the mortgage itself is a liability but the house is an asset. I like to see a mortgage as a forced savings plan because every mortgage payment that you make, you’re building equity in your home. Sure you’re paying interest but over time the interest payment of each mortgage payment will decrease. And depending on where you live in the world, such as in the US, your mortgage interest is tax deductible.

Good Debt: Mortgage – The Cons

They do say “house rich, cash poor” for a reason. If you live in a beautiful home that you can’t afford then you’re living well beyond your means. Sure the bank might have lent you the money for the mortgage but in reality you might not have been ready to take on a mortgage so big. You might have thought that you would have a mortgage helper in your basement tenant but never found that tenant are struggling to make mortgage payments. Whatever the reason, your mortgage shouldn’t be too big and if it is, you’re hurting yourself not only in terms of lifestyle but having too much debt is stressful.

Good Debt: Education – The Pros

Other types of good debt include education where you’re spending money to improve yourself and potentially increase your earning potential. You could back to school to do an MBA (like I’m doing) or go for something more specialized like cooking, nursing, IT, etc. The options are limitless and you’re basically investing time and money into yourself, which is never a bad thing.

Good Debt: Education – The Cons

Not all education is equal in terms of debt. Unless you’re studying something that will lead to a better job, it isn’t likely to be a good investment. I’m only talking monetary terms here, if you’re trying to start a new business and need a new skill or want to learn something just because it’s been your long time dream, then that’s amazing! But even then it isn’t exactly the best debt you could be taking on as it is hurting your earning potential. There’s likely more than one opinion for this and I think it’s perfectly find to be taking on debt to study what you have a passion for just make sure you have a plan after graduation to pay for your student debt!

Good Debt: Business Ownership – The Pros

Starting or buying a business has its risks, as I’ll talk more about later, but it also gives you the chance to learn tons and potentially give you the opportunity to work for yourself. As an MBA student I can tell you that I’ve heard time and time again that you can only learn so much about business from books and lectures and that it’s all about hands on experience. While I don’t completely agree because I do have hands on experience and what I have learned so far from my MBA courses has been amazing, I agree completely that experience is the biggest teacher.

In fact, even if you do end up losing money with a business think of it as tuition. Sure some started businesses and succeeded in their first try but many more have failed sometimes several times, Bill Gates, Henry Ford, Walt Disney…just to name a few.

Good Debt: Business Ownership – The Cons

Starting a business is great but a large number of businesses fail. So if you are expecting to start a new business and earn millions or even enough to replace your day job right away without any experience of running a business, you’re being overly optimistic. I’m not saying it’s impossible but I will tell you that it will likely require a huge amount of work and cause a ton of stress.

And if you’re quitting your day job, you’re losing something that is very stable and might not be able to go back if your business isn’t successful. That’s why it’s important to have savings to fall back on if your business fails. I don’t want to be overly pessimistic but I want you to be realistic and be ready for anything if this is the path that you choose to take. I’m actually a huge fan of starting a business and think that it can accelerate the pace that you reach financial freedom, but I just want you to understand that there are risks involved.

Good Debt: Real Estate – The Pros

Investing money in real estate is considered good debt. While your home is also real estate and you could definitely include it here, I’m leaning more towards pure real estate investments. Real estate has long been perceived as a very stable source of passive income and capital gains. Yes, we had the horrible sub prime mortgage crises, which led to insane drops in real estate prices. But if someone was buying during that period with moderately high interest rates and real estate prices rising through the roof, that was almost speculation and not investing.

For your real estate investment to be good debt, it has to be thought through. Many of the people that were buying during that time were looking to flip their homes and make a profit, usually a capital gain. But in reality, capital gains shouldn’t be your main reason to buy real estate, wherever possible you should look to have positive cash flow. That means that whatever income you earn from the property should pay for all expense including the mortgage, maintenance, etc. and leave you with some extra cash. Investing in real estate is a topic for an entire book and I’ll eventually tackle the topic in a different article!

Good Debt: Real Estate – The Cons

Real estate is great but it’s also risky. There’s something called liquidity risk, the “marketability of an investment” as Investopedia puts it. Basically I’m talking about how easily you can get your money back from the market if you were to sell real estate, as you might imagine, not very quickly. You might get a quick sale if the market is hot but if it isn’t you’ll likely have to sell for a loss or a huge discount if you want to sell quickly. You also have to factor in legal and realtor fees, which can be substantial.

That’s why you need to have a very long-term mindset when it comes to real estate investments. If you want to flip in 1-2 years, forget about it. Yes you might know someone or have seen a “guru” on TV telling you about how they’ve made millions by flipping houses. But, have you talked to these people after the subprime mortgage crises?

I mentioned this in the pro part real estate as good debt, but cash flow really is king. If you’re betting on the capital gain of a property and ok with a negative cash flow, then every month that goes by you’re shelling out cash that you’ve earned elsewhere. I don’t see that as a good investment.

Good Debt: Investing – The Pros

Good debt in investing means that you are extremely risk tolerant because you are borrowing money to invest money. If you know what you’re doing, then this can accelerate the growth of your investment portfolio because you’ll have more funds to invest and the interest you pay the borrowed funds will be interest deductible (depending on where you live). You can use leverage in a number of ways the most common being borrowing funds from your line of credit or home’s equity or have a margin account through your investment broker. I hope some alarm bells went off when I said borrowing funds from your line of credit or home equity, let’s now look at the cons.

Good Debt: Investing – The Cons

If you don’t know what you’re doing borrowing to invest is a sure way to the poorhouse. This is because investing in stocks on it’s own can be risky but if you borrow to invest not only can you lose the funds you invest, you will owe money on what you’ve lost. You’ll of course have to continue paying interest on the funds that you’ve lost money on.

Now if you’re losing money investing, that isn’t investing, it’s speculating. I define the two differently because they inherently are different. Investing is when you have a plan and take controlled risk and even if you have a paper loss, that loss should be within your plans. Even if you go through financial crises like we did back in 2009, it hurts but you still have your plan and know exactly what to do.

But if you’re speculating, it’s a different story. You’re trying to make money from the stock market or whatever market you’re putting money in. Most likely it’s for shorter time frames and this is asking for trouble. I’ve heard it said many times, if a professional money manager with all the information and technology in the world struggles to make money on a consistent basis in the markets, how can a solo trader beat them consistently? I’m strictly talking about speculating here, with investing I do believe that you can beat fund managers if you’re patient and look for prime opportunities as fund managers are often under more pressure to perform which can actually hinder performance.

So you see, borrowing to invest is dangerous. It can ruin people financially and I do not recommend this unless you really know what you’re doing. I put this as good debt only because it really is good debt if you know what you’re doing.

Bad Debt Types

Now let’s get into the bad debt types. This is pretty self-explanatory but I think it’s important to go through the list just in case you think some of these are good debt.

Bad Debt: Any Credit Card Debt

Credit card debt is likely one of the worst types of debt you could possibly be carrying. If you a balance on your credit card you should cut it up and not use another credit card until you pay it off completely. It doesn’t matter what interest rate you’re paying on the credit card it’s likely extremely high. Even if you have a “low interest” credit card that’s 10% that’s still ridiculous.

I should point out that I’m a huge fan of credit cards. You get points for your purchases, which you could use for amazing rewards, it helps you build your credit rating and you can delay paying for stuff. But all this only applies if you are disciplined and pay all of your entire balance in full every month. Yes, you read that right not the minimum payment, but the full balance every month. If you can pull that off then you’re an extremely smart credit card user. You aren’t going to be the best customer for the credit card company because you pay absolute no interest, but as a consumer this is what you should strive for. If you can’t pay everything off every month, you shouldn’t have a credit card in your wallet, harsh but that’s reality

If you don’t know what the interest rate you’re paying on your credit card is, grab you bill now and take a look! The annual percentage rate (APR) that your credit card quotes you, which by the way is probably around 15-20%, isn’t the same as the effective annual percentage rate which is generally higher. Just trust me on this one, read this article on Nerd Wallet if you want to know more.

Bad Debt: Credit Card Cash Advances

In my opinion cash advances is likely the worst form of debt. It leaves credit card debt in the dust because with credit card cash advances, you don’t get any rewards and you pay daily interest. You may also pay a higher interest rate for cash advances as well, avoid cash advances at all costs. Cash advances should be your absolute last resort. Enough said!

Bad Debt: Car Payments

Many of us need a vehicle to commute to work and having car payments is a no-brainer for many. I agree, however the issue isn’t about having car payments it’s about the type of vehicle that you drive. If it’s a bare minimum car that gets you from point A to B and you bought a car well within your means then that isn’t considered a bad debt, it’s almost a decent investment. I say that with caution because cars have insane depreciation rates. Some say that the instant you drive a brand new car off the lot, it loses half its value. Ok, that might be a bit of an exaggeration but you get the point.

To take the smart car purchase point one step further, you could consider buying a used car that is maybe 2-4 years old since this way save you a significant amount of money. I’m talking thousands of dollars and potentially more if depending on the make of the car, just something to consider.

So what’s so bad about car payments then? Bad vehicle debt is if you go over your budget and buy a car beyond your means. If you didn’t do your homework before heading off to the car dealership, the car salesperson will likely ask how much you can afford or more specifically what your monthly budget for a car is. If you say $350, they’ll lengthen the loan term. Or they’ll give a “deal” on the interest rate but trust me, when you have a car payment for 8 years, it’s no deal.

Never tell them how much you can afford monthly. Know exactly how much will pay for a vehicle in full. Do your homework and have a ceiling price that you’re willing to pay for the car even if you are getting a loan. When I bought my second car (I have since gotten rid of it, thankfully) I took two of my closest friends and we had to negotiate for a solid 2 ½ hours before I got the deal I wanted. Was it worth the time? I’m not sure but I’m glad I didn’t pay them hourly I bought them lunch and they apparently went with it! Luckily my friends were great negotiators. This is because we knew what my ceiling price (maximum amount) I would pay for the car. And yes, I was satisfied with the price, but it was a draining experience.

Bad Debt – Consumer Debt

This could be anything really but when I hear consumer debt, I think of store credit cards. This is pretty much like regular credit cards, only store credit cards often have a higher interest rate. If you shop at a certain store on a regular basis it could make sense to get their card since you get some sort of sign up bonus and can benefit from their point system, but just like with credit cards you should never carry a balance.

Bad Debt – Payday Loans

Ok I lied, payday loans are the worst type of bad debt you could possibly have. Payday loans are exactly as the name suggests, they give you an advance on your pay check, take a fee and charge an interest. Some places charge $15 for every $100 that you borrow. That’s 15% off the bat plus the ridiculous interest rate that they charge. But what you need to realize is that these loans for usually for spans like 2 weeks. So imagine that you’re paying 15% on a 2-week loan. Doesn’t that sound insane? Unless it’s an extreme emergency don’t take a payday loan.

Debt in General and how you should approach paying them off

Debt is a touchy subject because many of us have some sort of debt. They say that wealthiest have large amounts of debt because they leverage and it’s often part of their tax planning, but that’s because those individuals are disciplined and can control their spending and their incoming cash flow far offsets whatever interest and principal payments they need to make.

I hope that this article clarifies what good and bad debt is. Good debt is good only in the hands of those that have discipline. Every single good debt that I listed can easily be just as bad as a payday loan or worse (imagine borrowing heaps of money to invest in penny stocks only to lose it all, yes that’s worse than a payday loan), and if you aren’t financially responsible think twice before taking on any sort of debt.

While I don’t agree with not having any debt at all because you need to start somewhere and having debt will teach you financial discipline. Start small. I started with a $500 limit credit card and built up my credit. I’m very grateful that my parents always told me to pay off my credit card balance in full because that habit has stuck with me and I’ve saved thousands of dollars in interest because I put absolutely everything on credit card when possible to take advantage of rewards.

If you’re wondering what debt to pay off first, start with the highest interest and work on paying that off first. Yes it might make seem like it’s easier to pay off the $1,000 loan with 6% interest compared to the $5,000 credit card with 15% interest, but in reality if you happen to have $1,000 to pay, you’re either paying off a loan that will charge $60 interest or a credit card that will charge $150 or 2 ½ times in interest. Always pay the debt with the higher interest rate!

Be careful with debt, but don’t be shy to use debt to your advantage, only if you’re capable of it! If you’re loose with money, get in the habit of keeping track of everything you spend money and try to think twice before buying anything, even if it’s a latte at Starbucks. And spend some time reading around on Freedom Nova’s financial planning section for ways to plan and save your money!

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