Good Debt vs. Bad Debt

Perhaps the most misunderstood concept in the personal finance realm, debt is something that should not be scoffed at.

Debt has helped to create countless millionaires and billionaires. It has also put at least as many people on the path to bankruptcy. The key to the former’s success is specifically using good debt to finance their projects. The latter took out bad debt which did not produce them something in return.

Not all debt is bad. Not all debt is good. Understanding the difference between good debt vs. bad debt is a key to unlocking your true potential for building wealth.

Let’s look at the battle between good debt vs. bad debt below:

What is Bad Debt?

Bad debt is debt that will not help you to build wealth or generate income. Bad debt does not provide you enough in return.

One of the most common examples of bad debt is most credit card debt. Usually, people will buy something that they could not otherwise afford and are then stuck paying 20% interest until they pay it off, which can take years for some. They might rack up debt to finance expensive vacations, eat at fancy restaurants, or purchase other luxuries.

The problem with financing those items (especially at such a high interest rate) is that they will not produce anything to help build wealth or generate income greater than the debt payment. Instead, the person will have to pull from other assets to pay it down for a net loss.

Bad debt happens when people ignore this fundamental question: would it make more sense to buy this with cash?

If the answer to that question is yes, taking out debt is not a good idea. It would be best to wait until you actually have the money to buy that item. Otherwise, it will only be driving you backwards. If you fall too far behind, you might suffer truly terrible financial consequences.

If the answer is no, then using debt might make sense. For example, if you can finance a used car (that you actually need for your job, let’s say) at 4% interest and then take the money that you would have used to buy the car in cash and invest it where you can make a 7% return, that debt is good debt. However, note that you already had at least most of the cash necessary to buy the car outright. We’ll learn more about over-leveraging in a moment.

What is Good Debt?

As you can hopefully tell by now, not all debt is bad. Lots of businesses and investors use debt to their advantage as they try to build their portfolios and make significant returns. Good debt is often called “leverage.”

One of the best examples of good debt is a real estate investor financing the purchase of an apartment complex. Let’s say the complex is worth $2,000,000. The investor could try to buy it with all cash. Alternatively, the investor can take out a $1,500,000 mortgage at 5% interest and only have to put up $500,000 in cash.

The expected return on the property is 10%, so taking out the mortgage at only 5% does not make the deal unprofitable. Instead, it allows the investor to use his or her remaining cash to buy more properties. Rather than only being able to buy 1 property with all cash, the investor can buy 3 properties using debt.

Meanwhile, those three properties will all be bringing in rental income that will be used to pay down the mortgages. The investor will build equity as the mortgages are paid down. The investor will also take home some cash flow each month after paying off expenses.

This debt allowed the investor to triple the amount of monthly rent he or she was bringing in. Obviously, it also tripled mortgage payments as well, but part of each mortgage payment is equity paydown, after all.

Over time, once the mortgages are paid down, the investor will have triple the income and appreciation than if he or she had locked up all available cash into one property. The investor will also be more diversified since all of his or her money would have been spread over three properties rather than just one. The debt also would have allowed the investor to get into those three properties much more quickly than having to save completely for additional properties with all cash.

Over-leverage

You can have too much good debt.

Let’s say you take out a $40,000 home equity line of credit. You want to buy a rental property worth $200,000. You take out a $160,000 mortgage from the bank to buy the property, and you use your $40,000 line of credit to cover the down payment. In other words, you are using 100% debt to finance the property.

Had you used cash for the down payment, the property would have cash flowed for $150 each month. Since you used the line of credit, it now loses about $50 each month.

But, worse yet, the market get’s hit with a nasty recession and rent decreases by $100 a month. Now you are losing $150 a month on the property. You also face a slight pay cut at your job. You now cannot afford to pay for the property because you over-leveraged yourself.

Over-leveraging is a common problem for investors. When times are good, investors often take out as much debt as they possibly can. When times are bad, those investors who over-leveraged crumble.

Warren Buffett, for example, makes sure to always keep a large pile of cash for his company to avoid a potential liquidity crisis. Income decreases in hard times while debt payments stay the same. If you do not have the emergency fund set up to cover yourself in hard times, you will feel the pain of over-leverage.

Finance with caution!

What About Student Debt?

Contrary to a somewhat popular belief among the personal finance community, not all student debt is bad debt.

This is best explained through an example:

You have a high school degree and could make $35,000 per year if you worked full-time. You are considering going to college, but you do not have any savings built up. To get a 4-year degree, you would have to take out $80,000 in debt at about a 5% interest rate. Alternatively, if you worked for those 4 years, you could reasonably expect 2% wage growth through each year, meaning your salary would be about $37,000 by the end of your 4^th year.

If you did get your degree and learned some valuable skills while at the university, you could reasonably expect to get a $55,000 per year job in your area. That is an increase in salary of $18,000 compared to what you’d have if you continued working through those 4 years, or nearly a 50% “return.” Compared to 5% interest, this doesn’t seem so bad.

But remember that you sacrificed nearly $150,000 in salary over the 4 years that you went to school. Combined with the $80,000 tag, that’s a $230,000 economic cost. Obviously, the decision to go to school is not as simple as comparing the interest rate on your debt to your expected salary increase. There are other opportunity costs as well.

But even with that $230,000 economic loss, your increase in salary from getting your degree (assuming a 2% increase in salary each year thereafter) will make up for that loss in approximately 12-13 years as you pay down your student debt.

In short, if you are willing to work in the job that you are aiming for for at least 12-13 years, your decision to go to college appears to make financial sense. However, you may also be forced to forgo many other opportunities, such as investing in a business or trying to make a return with your money elsewhere. After all, you will be pouring a significant amount of your income into paying down your student loans. That is, effectively, an additional interest cost.

Of course, for many, college is often for more than just income growth. But that is a primary motivation for a large number of students. Despite this, so many of those students do not seriously evaluate whether school is actually worth it economically. Figure out whether taking out student debt would be bad or good debt given your specific situation.

Risk vs. Reward

You can create bigger returns using good debt. However, this is not without risk.

When you have no debt, you will not have to worry about paying other folks first if things go south. At the same time, without using debt, you will likely forgo many opportunities that could help you build wealth rapidly and succeed financially.

Generally, the more good debt you use, the higher your potential reward but the higher your risk. Conversely, the less debt you use, the lower your potential reward but the lower your risk.

There is no right answer for how much risk you should take. Some people are far more comfortable with a lot of risk. Others would rather keep everything in cash and avoid as much risk as possible.

When in doubt about your strategy, consult with a licensed financial professional to figure out what adjustments might be best for you!

Conclusion

Everything in moderation. That is certainly true for debt. Too much debt, even “good debt,” can be a bad thing. But not using debt at all can prevent someone from making big financial gains.

Debt is a weapon; it must be used responsibly to avoid unnecessary injury. Good debt is used to produce a positive financial return while bad debt is used to finance things that a person cannot afford and which will cost them over time.