Good Debt vs Bad Debt

connorsmith (41)in #investing • 6 years ago

It is crucial to understand the difference between good debt and bad debt. Debt, when used correctly, can be an incredible catalyst for reaching your dreams faster. While if used incorrectly it can drive you into the ground, and ruin your life.

Good Debt

The simple rule is if it increases your net worth or has future value, it is considered good debt. By borrowing money you can gain access to more opportunities and can make more money. Generally, loans for good debt have lower interest rates and help individuals increase their net worth and their income. Here are some examples:

Business Loans- By borrowing money to start or grow a business, you can expand quicker than you would without the debt. As long as you use the money for important projects to grow the business, it could produce a very good return on investment, and be very worthwhile.
Student Loans- It is sometimes a smart idea to borrow money to invest in yourself, and your education. This is debatable, however, because it can either pay off tremendously, or it could be a very bad decision. College is getting more and more expensive every year, and it is important for future students to weigh all the options and determine if it is really a good idea to take out loans. The answer to that very complex question depends largely on what you want to study, and whether it will be worth the cost.
Real Estate Loans- There are a variety of ways to make money with debt in real estate. The simplest strategy is just to buy a house, live in it for a few decades, and then sell for a profit. Debt can also be used to generate income, by investing in a house or apartment to rent out. Commercial real estate can also be an excellent source of cash flow and capital gains for investors.
Investing Loans- Real Estate, is a very safe way to invest with debt, but it is also possible to invest in more risky securities to make even bigger gains. By leveraging your money in the markets, you can generate a larger return on investment. Note that all securities have different levels of risk and reward, and it can be risky to utilize debt in certain investments.

Bad Debt

Bad debt is very dangerous. Bad debt is any loans used to buy unnecessary goods or services with no lasting value. Some examples include:

Car Loans- New cars are expensive off the lot, and most cars depreciate extremely quickly. It is not smart to use debt to buy an expensive car that you can't really afford. And when you eventually go to sell it, it will be worth only a small fraction of the money you paid.
Consumer Debt- Borrowing to buy unnecessary things, at extremely high interest rates, is extremely reckless. Clothing, vacations, fast food, groceries and gasoline, are all items commonly bought with debt. Generally, people use credit cards, that have outrageous interest costs. So unnecessary purchases with borrowed money should be very limited.

Conclusion

Next time you plan to make a big purchase with debt, take a moment to consider if it is good debt or bad debt. If it is bad debt, then ask yourself if it is really necessary, because every penny spent on interest is money that could have been used more wisely elsewhere.