Good Debt vs Bad Debt

Growing up, it is so heavily engrained in us that debt is bad. We are told to never get into debt because it will financially ruin you. Dave Ramsey is a public figure who pushes this ideology. His philosophy is to never take out a loan with the only exception being a mortgage on a house. However, should we be taking this advice verbatim? NO! This article will help define what is good and bad debt. It will help you avoid bad debt and use good debt to your advantage.

Bad Debt

There certainly is bad debt out there, but what defines bad debt? Simply put, bad debt is borrowing money that does not create more money for the borrower. Auto loans, credit card debt, and payday loans are all examples of loans that are generally bad debt. Even mortgages and student loans can be considered bad debt!

The reason these can be considered bad debt is the result of these loans not generating any monetary benefit for the borrower. When buying a car, as soon as you drive the car off the lot the car loses 50% of its monetary value. You took out a loan on a car for $30,000 and now own an asset that is only worth $15,000. On top of that, unless you use the car to make money by ubering or door dashing, the car is not generating any income for you. By taking a loan on a car it is increasing your monthly expenses while not increasing your monthly income.

Credit card debt can be one of the worst forms of bad debt. Most people use credit cards to pay for small expenses. Generally these expenses are not generating income and, if not paid back by the end of the month, are hit with a interest rate upwards of 25% APR.

Many people assume that student loans are the only acceptable debt that is good to have. However, that is not always the case. Student loans can be good debt, but it is based on how much student loan debt it'll take to graduate and how much your wage will increase with that specific degree. If you are taking $100,000 for a student loan with a 7% interest rate on a degree where you will only make $20,000 - $40,000 a year after graduating, this student loan could be seen as bad debt. With a loan this large you would be paying $7,000 dollars in interest every single year. There are many job options that pay $30,000 - $50,000 a year without a degree. So by taking such a large loan for little to no increase in pay would be considered bad debt. If you only had to take out $20,000 with an interest rate of 3% in order to get a job that pays $70,000 - $100,000 a year, this would be a good debt to take. The difference in the two examples is that in the first example you're spending an extra $7,000 dollars a year to make the same wage that you could have made without a degree. This doesn't include the principal of the loan that you would have to pay back. In the second example, you are paying only 600 dollars a year in interest and are making an extra $20,000 - $50,000 a year.

Another example of bad debt that in generally looked at as good debt is a home loan. The reason it is looked at as good debt is the idea that the house value will go up over time which is really earning you money. However, what people don't realize is that the house's value is going up, but if you never intend to sell, the value in the house is not earning you a higher income. In fact, larger houses will generally have higher expenses such as utilities and property taxes. Owning a home is great, but be careful on what you are spending on your home.

Good Debt

What is good debt? Put simply, good debt is borrowing money in order to return a larger income to the borrower. You have probably heard the common phrase, "it takes money to make money." This quote couldn't be more true! What separates the upper class from the middle and lower economic classes is how they get there money. These millionaires and billionaires aren't making all their money by making coffee at home instead of going to Starbucks and by never taking on any debt. If you were to research on most millionaires and billionaires they are usually millions of dollars in debt. However, it is mostly good debt.

The Dave Ramsey's of the world will tell you that you can only save and use your own money in order to get rich, however, this is a downfall of most people. The key to the rich's success is debt! An example of how a wealthy individual will use debt is as follows. They will go to the bank to get a loan on a house that is worth $300,000. They will invest their own money for a down payment of $60,000 and take a 30-year loan of 5% to cover the other $240,000. With this loan their monthly payment to cover the principal and interest would be roughly $1,550 a month. However, they will use this property as a rental property and rent the house out for $2,550 a month. This rent amount is enough to cover the principal and interest each month. Therefore, at the end of the 30 year loan the landlord will have a fully paid for house and the houses value has appreciated to $500,000. The best part of this? the landlord only paid a total of $60,000 dollars to own a $500,000 dollar house because the renters paid the interest and principal of the loan. In addition, the owner also makes an additional $12,000 dollars a year in added income. If that isn't great enough already, the landlord can also save money by capitalizing on various tax breaks such as depreciation. The $240,000 debt would be considered good debt because it generates an income that convers the interest and principal, as well as, generates additional income.

Without using any debt to finance this venture, you would have to save $300,000 on your own. If you only are making 50-80k a year, this could take you over 10-15 years to finance yourself. By financing with your own money, it would take close to 10 years before you could buy your second investment property outright. The equity you would own in your investment properties after 25 years would be $600,000 and only an additional $61,200 a year towards your income. Instead, you could save 60k every 3 or 4 years and put a down payment on a new investment that'll generate an additional $12,000 a year. By the time you would be able to buy the first house outright with your own money in the first example, your $12,000 income from each of your 5 investment properties would be able to pay for the down payment of your next investment property on their own in a single year. Therefore, you would be able to get a new investment property every year after. In those 15 years, you would also own over 1 million dollars in equity in your investment properties and 60k a year of added income. Of course the prices vary depending on location and the market. This is simply an example of how good debt works.

This ideology can be extrapolated to other investments outside of real estate. It also works for investing in the stock market or within a personal business. Most businesses rely on debt to generate more revenue. A business might take a loan to buy machinery to produce more products for a lower cost. It is important to note, while taking on debt to make more money can be smart and earn you an exponential amount of money, it also carries risk. If you take a loan for an investment and the income generated does not cover the cost to pay off the interest of the loan, it can cause major issues such as bankruptcy or a reduced income. This is why many affluent individuals create an LLC to use for their investments and debts. We will post another blog shortly on the benefits of having an LLC in the near future.

Rich Dad Poor Dad

The idea of good debt is covered very thoroughly in the book Rich Dad Poor Dad by Robert Kiyosaki. It covers what good debt is and how to escape the "rat race" and earn passive income. It will also teach you how to manage your expenses and understand finances. If you have not yet read this book, I highly recommend it. This book easily breaks the top 5 books that I have ever read. If you are interested in this topic and have not yet read Rich Dad Poor Dad and want to learn more, I have attached a link to the book right under this paragraph.

Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor Do Not!

"The poor and the middle class work for money. The rich have money work for them."

Buy Now

This is an amazon affiliate product.

Conclusion

In conclusion, navigating the world of debt requires a nuanced understanding that goes beyond the black-and-white advice often given. While Dave Ramsey's philosophy warns against most forms of borrowing, the distinction between good and bad debt becomes crucial. Bad debt, like auto loans and high-interest credit card debt, doesn't contribute to increasing income and can lead to financial pitfalls. On the other hand, good debt, when used strategically, has the potential to leverage investments and generate additional income. Whether it's in real estate, the stock market, or personal business ventures, the key lies in making informed decisions that align with the potential for returns. So, instead of fearing all debt, perhaps it's time to embrace a more nuanced approach, acknowledging that sometimes, it takes smart borrowing to make money work for you.

Disclaimer:

The information provided in this content is for informational purposes only and does not constitute financial advice. The content is not intended to be a substitute for professional financial advice, diagnosis, or treatment. Always seek the advice of your financial advisor or other qualified financial professionals with any questions you may have regarding your personal financial situation.

Investing involves risk, and past performance is not indicative of future results. The content creator does not guarantee or warrant the accuracy, completeness, or currentness of the information provided. Any reliance on the information in this content is at your own risk.

Readers are strongly encouraged to conduct their own research and due diligence before making any investment decisions. Consideration of individual financial goals, risk tolerance, and specific circumstances is essential. The content creator and platform disclaim any liability for any direct, indirect, incidental, special, or consequential damages arising out of or in any way connected with the use or reliance on the information provided.

Remember, financial markets are subject to various factors and can change rapidly. It is important to stay informed and consult with a qualified financial professional for personalized advice tailored to your specific situation.