Believe it or not, not all debt is "bad" or evil. Taking out a loan for certain circumstances can actually be a GOOD thing if it has the ability to make you money now or in the future. There are definitely die-hards out there that say no debt can be good debt, but in reality most people will need to borrow money to buy some of the bigger items in life like a house or a car.
The first step in recognizing the difference, is to provide a definition for both good debt and bad debt.
Good Debt:
Good debt is borrowing money that has the potential to make you money now or in the future (increase your net worth)
Bad Debt:
Bad debt is a loan taken out to purchase depreciating assets, or a loan that doesn't have the ability to make you money
Now that you have definitions to refer back to, let's dive into examples of each:
The "Good Debt" bucket:
Taking out a loan that gives you the opportunity to generate more income is the goal here. Some scenarios can be pretty easily identified as good debt, but some can be a bit of a grey area. Let's discuss a few examples.
Investment Property
Buying a piece of real estate as an investment is probably one of the oldest methods used to build wealth. There are really only two things we're interested in here; appreciation (house price growth), or yield (how much rental income). Some investors look for appreciation potential, rental yield, or both, depending on what their goal or strategy is.
Without going down the rabbit hole here, let's just talk about why it's considered good debt. Basically, it fits our first definition. It has the potential to make money either now or in the future. You're either banking on the property going up in value over time so when you sell it you make a profit, or you want the property rent to cover the mortgage and expenses and leave you with extra cash, or both!
Student Loan
You might think, "how does this class as good debt?!". Hear me out. You're taking out a loan to further your education and ultimately increase your future income. This can lead to increased job opportunities because you've completed a degree or course in the field you wish to have a career in. You're investing in your future self, which usually pays the best interest. Choose carefully though, as choosing a course or degree that has little or nothing to do with advancing your career may be a poor investment with no payback potential.
Your Business / Small Business
Starting a business of your own allows you to be your own boss and make your own rules. To some, this is great. Making money is also a common reason for starting a small business. Generally speaking, if you reinvest the money you make back into the business to grow it, and have a strong passion and desire to succeed, you'll likely be successful.
If you have a business of your own or are involved in a small business, taking out a loan to scale your operation can greatly boost your performance potential. Say you owned a coffee shop that was doing pretty well and you wanted to open up another location in a popular part of the city, but you were only clearing $10k/month profit. This is great, but building up enough cash to fully set up the other location could take years. This is where it could make sense to get a loan to fit out your new area, as it's likely to have a great return on investment.
The "Bad Debt" bucket:
Borrowing money to purchase things that depreciate in value, or have no potential to make you any money is a bad idea. It's often referred to as "consumer debt". Put simply, if what you're borrowing for isn't likely to go up in value or make you money, you shouldn't borrow for it. This is the kind of debt you want to avoid.
Credit Cards
I want to start off by saying the USE of credit cards is not the bad thing here. It's CARRYING A BALANCE that's the culprit. Studies have linked the use of credit cards to overspending and this is definitely something you need to be conscious of if you choose to use a credit card.
Use a credit card like you would your debit card. If there's no money left in your debit account you can't spend any money on your debit card, right? Well, think of that when using a credit card too. If there's no money in your debit account, don't put it on your credit card because you can't afford it.
Anywho, now that I've got that out of the way, let's jump in and see just how bad credit card debt actually is. The average credit card debt for the US is $5,331, $4,154 for Canada, and $2,889 for Australia (not pictured)! Most credit card interest rates are close to 20% APR (Annual Percentage Rate), so with that kind of balance it can make it extremely difficult to pay off due to compound interest working against you.
Auto Loans
Just about everyone loves to drive nice cars. In fact, I'm willing to bet if I asked someone would they rather drive a beat down Datsun 180B (an old Nissan model) or a well maintained, flash looking SUV, they're going to say the SUV every time.
The thing is, that old Datsun might be worth $500 and still functioning and roadworthy, and the SUV could be upwards of $50,000. Most folks would pay cash for the $500 car, but take out a loan for the $50,000 car.
If you use a car for business purposes it can makes sense to finance it, due to the tax write-offs that are possible (we won't cover this today). For most of us though, we should avoid taking out a loan to buy a car - especially a new one! - for one simple reason; It's a depreciating asset.
Depreciate just means "go down in value over time". If you borrow money, like a $30,000 loan over 5 years at 9% for a used car (rate for used car is nearly almost higher than new), you'll pay $7,365 over the life of the loan in interest payments just for the privilege of having the loan!
If you were able to invest that $7,365 at an average annual return of 7% and let it sit for 30 years, you would have $59,778. Eye- opening when you look it like that, isn't it?
It's all well and good for me to say "don't get a loan to buy a car, buy with cash instead", but that can be quite hard for a lot of people. If you do opt to get a loan I'd definitely recommend a quality used car over buying new, preferably around 2-3 years old (most of the depreciation happens in the first few years), and prioritize paying it off a quick as possible to save yourself a ton in interest.
Personal Loans
Who has borrowed money to go on a holiday or purchase things for the house before? I know I have. We borrowed money with the intention to renovate a portion of our house back in 2012. Little secret, none of it went toward the house. In fact I can't remember what we even spent the money on!
The average rate for personal loans is around 9.63% at the moment, according to Business Insider. However they can range from 6% all the way up to 36% depending on the lender.
Borrowing money to purchase clothes, appliances, vacations or other goods and services isn't a wise financial move. Every dollar you spend comes at a premium of whatever the interest rate is for the loan. You're much better off saving to pay for any of these items.
CONCLUSION
Recognizing the difference between good and bad debt is crucial to either making money or costing you money. Good debt always has the potential to increase your net worth while bad debt just ends up putting you in a vicious payment cycle.
Always endeavor to pay for things like cars, clothes, appliances and vacations in cash, and avoid any interest payments. If you can't pay for it in cash, you can't afford it. If you do get a loan, pay it off quick smart. Don't get stuck in the debt trap!
Blake - FIRE with a family