What is Debt?
Debt is anything that is borrowed by one party from another, but in this context the focus is on money borrowed. When someone borrows money, there’s usually an arrangement for the debtor (person who borrows the money) to repay the creditor (the person who lends the money) at a later date, usually with interest.
Because most debts attract interest, and in many cases compound interest (interest is charged on interest), most people view debt as a bad thing but a necessary evil to help them out of a jam.
There is even a certain stigma that is attached to the word “debt” to the point that some people don’t even like to talk about it if they fell victim to it. In fact, some debtors would never openly admit that they’re in debt because they feel that others will look down on them since being debt-free is commonly advertised as the sensible way to live.
But while it may be possible to live completely debt-free, it is not necessarily the wisest choice. Having debt can be a very good thing,
depending on the type of debt we’re talking about.
Good Debt vs Bad Debt
There are two types of debt: good and bad. Good debt is usually used to purchase a home for you and your family to live, for investments that put money in your pocket, or helps you to increase your wealth. Bad debt is a burden, and it takes money out of your pocket.
An example of bad debt is the debt you incur from buying liabilities like expensive electronic gadgets and clothes that have very little value a few months after they’re purchased. These debts are often on credit cards that attract high interest rates.
Good debts usually attract a lower interest rate, and depending on what you use the debt to do, the interest may even be tax-deductible.
For instance, my husband and I used zero percent balance transfers on our credit card to start up our management company, and we borrowed money in the form of mortgages to purchase our investment properties. We also used funds from our line of credit for the down payment for some of these properties. All the mortgage interest, and any interest that accrues on the line of credit are tax-deductible because they are used for business purposes.
These are examples of good debts and the benefits on these loans are two-fold as well.
Apart from the tax break on the interest accrued, over time, the value of the property management company increased as the number of properties managed rose. Also, the values of our rental properties appreciate every year. Once enough equity was built up in the properties, from mortgage paydown and appreciation, we refinanced them and used the money to pay off the line of credit. This gave us access to more funds, which we reused to purchase more real estate, thus increasing our property holdings.
This is actually why all debt is not considered bad. In fact, this strategy is so phenomenal, it helped us to realize gains that we would never have obtained if we were waiting to save enough funds to purchase more real estate, or to start the management company.
It is consumer debt—the debt people use to buy want-to-haves—that is considered bad. Sometimes the things bought are thrown out long before they can afford to pay off the debt. They use credit cards and loans to buy things that they do not need, often because of impulses and emotions, and frequently because of the need to compete with or impress people they don’t even like.
And I’m not bashing all consumer debts; sometimes circumstances—such as loss of a job, death of a loved one, and job relocation—require that you take on some consumer debt. Why?
Because I don’t believe you should take money from your savings every time unexpected expenses come up. A consumer loan can help to care for yourself or your family while you relocate or seek new employment. It could also be used to purchase a plane ticket to attend a funeral, or to help family members cover funeral expenses. I too had to take on some consumer debt over the years, but these debts have always been for a very short time.
And I usually use my credit card first, to capitalize on the no interest grace period, which gives me a longer time before interest starts to accrue. But if I’m unable to pay off my credit card, I use my line of credit to cover the balance because the interest rate is much lower — plus lines of credit attract simple interest unlike credit cards that attract compound interest.
So there’s nothing wrong with taking a consumer debt, but the goal should be to get out of these kinds of debt ASAP. When in such debt, cutting back on some spending where possible so that you can clear the loan as fast as possible should be your primary focus.
Here are some examples of good and bad debts:
- Mortgages – homes usually appreciate in value
- Business start-up loans – most successful businesses start with even shareholders loans
- Student loan – if it provides knowledge to put money in your pocket
- Loans to purchase precious metals that keep their value or appreciates
- Loans for investments that yield a greater rates of return than the loan attracts
- Loans to purchase consumer items like clothes, shoes, furniture, and electronic gadgets
- Car loans – if the car doesn’t put money in your pocket
- Payday loans
- Credit card cash advance loans
- Vacation loans – if you don’t see yourself paying off the balance soon
The takeaway here is that consumer debt should be considered as a means to a very short end. They attract higher interest rates, the interest accrues is not tax-deductible, and if you’re not mindful soon they will become very bad debt, hurting your bottom line, and negatively affecting your lifestyle.
In a nutshell, good debt is using OPM (other people’s money) to increase your cash flow and build your wealth. So this is the only debt that you should have.