If you are like almost everyone in the United States, your first chance to use debt was to buy something that made you poorer. It might have been a car loan, some nice meals charged to your credit card, a mortgage on your home, or even a college education. In many cases, this use of debt might have led to enjoyable, memorable experiences rather than regret. What it didn’t do was put money in your pocket.
Some cases are obvious, where debt becomes such a financial drain, that it traps a person in a life of servitude to those who loaned them the money. Payday loans and overwhelming credit card debt come to mind. What might not be obvious is that any time you have to work harder in a different part of your life to pay for a debt, means that that debt is . . .
. . . Bad Debt!
Contrary to popular internet wisdom, even the mortgage on your home is bad debt because you have to work at an unrelated job to pay for that home loan. To be clear, I am not saying that it is a bad idea to take a loan on your primary home, but rather that a home loan puts a corresponding burden on a different part of your life. Your home loan may be a good decision overall, but it still has a major cost. Also contrary to popular opinion, loans for education are also bad debt because your school will not ever pay back your loan for you. Rather, you usually have to get a job–related or unrelated to your education–in order to pay back the loan.
The skill of recognizing when you are about to use bad debt, gives you the chance to stop and think critically. Will this thing that I am buying with bad debt bring me so much value and joy, that I will be happy to work extra to pay for the bad debt?
On the other hand, what if you borrow $10,000 from a lender that charges you $500 interest every year. Then you invest that money in a business that gives you a $1,500 profit every year? Your loan would lead directly to that business that pays your $500 interest expense for you . . . AND puts $1000 in your pocket. What you don’t have to do is to work at a separate job to pay your interest expense. This kind of debt feels a little like . . .
. . . Good Debt!
If you borrow money and spend it on something that directly makes you more money that what you pay in interest expense, then congratulations! You have good debt. An example of this would be a retailer who borrows money to buy merchandise to sell at a mark up. Another would be a bank that borrows money at a particular interest rate, then loans out the same money to home owners at a higher interest rate.
A critical first step that you can take is to eliminate as much bad debt from your life, which will make it much easier to build your wealth. Imagine trying to fill a leaky bucket with water. Once you plug all the holes, the bucket fills faster and stays filled. Eliminating bad debt is like plugging the holes in your bank account, which allows it to fill faster and stay filled.
You probably have already suspected that good debt can be used to build wealth. What I am NOT saying is that debt is always a safe thing to use, or that it should be used in every investment. You can certainly make money with what ever cash you already have. However, when you find opportunities that you understand very well and which have limited, quantifiable downsides, then good debt can be an effective tool.
Your first step after learning the types of debt and after reducing your bad debt, is to learn as much as you can about the features and nuances of borrowing money. Talk to other investors on how they use debt, what issues they look out for, what problems they have encountered in the past. Talk to a banker about how their most successful clients use and don’t use debt. Be sure that you know for certain what would happen and what you would need to do if you have problems paying back your debt. Using debt is a serious business, even when you are using good debt. Even if you decide to never use debt, you will learn a tremendous amount about how a the financial world works.
Bad debt versus good debt. Shackles versus useful tool. Knock out the bad, and start learning about the good.