Good Debt vs Bad Debt
Knowing when to use debt
Young people especially, but perhaps all people, seem a little confused about when to take on debt or not. Sound bites fly around social media without much context. Assertions such as “Rich people don’t use their own money, they use other people’s money”. This requires a little unpacking though to fully understand what this means.
Good Debt
Good debt is debt that builds wealth.
One simple rule is, can you get a return on deploying the debt, that is greater than the interest you are going to pay on the debt.
In today’s market, you can borrow money for 2%-4% interest. There are multiple ways to get a return that equals or exceeds that, so it is an enticing time to raise debt and put it to work. This is especially true when considering real estate investments, whether a primary residence of an investment property.
If interest rates were 6% or higher, then raising debt for investment would be a more complicated calculus, because to get a return of greater than 6% may entail taking on more risk. For those using credit card debt for investing, then the calculus is even more complicated. What is the probability of getting a return of more than 18%+.
Investing has two basic types of returns, capital gains and cash flow. Both have to be considered when calculating the benefits of debt, as do expenses. However one simple and basic rule is the probability of getting a return that exceeds that of the debt cost — the interest on the debt.
Bad Debt
Debt to buy a depreciating asset like a car? Bad debt. Debt to buy new toys? Bad debt.
To be clear, people who have bad debt are not bad people, they have just chosen to forgo future wealth for he sake of immediate pleasures. That is a legitimate choice, and many of us make that same choice. We are humans, and sometimes living involves bad debt, either for a great experience or because life happens and there is an unexpected expense.
Bad debt, debt that is not going to build wealth, happens. There is no point beating yourself up when it happens. However, it should be a conscious choice, and it should be a manageable level.
Conclusion
Rich people don’t get rich by loading up on loans and credit card debt for a bottomless pit of instant gratification. They get rich by leveraging debt when they can use it to build wealth. There are many examples of this, some of which will be explored in future blogs.
Disclaimer
Past performance is not indicative of future results. There is no guarantee of any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment discussed on this website. Strategies or investments discussed may fluctuate in price or value. Investors may get back less than invested. Investments or strategies mentioned on this website may not be suitable for you. This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. You must make an independent decision regarding investments or strategies mentioned on this website. Before acting on information on this website, you should consider whether it is suitable for your particular circumstances and strongly consider seeking advice from your own financial or investment adviser.
