If you’ve been reading up on our blog for the past few months, it might not come as a surprise to you any more – there are clearly distinguishable features that separate good debt from bad debt. Joined together, these features act in a very particular way. Can you guess what it is?
If you guessed that good debt expands your wealth and bad debt acts to the detriment of it – you guessed correctly. Cheers, highest marks!
For those of you who guessed incorrectly, this blog entry will try and shed some light upon the types of good and bad debt, and how you may be able to use this knowledge to your benefit.
What makes a good debt?
For some, either through personal experience or passed down knowledge, there is no such thing as good debt. Indeed, there are hundreds upon thousands of proverbs about how debt is bad or at least an unfortunate thing, spread throughout the history of our species.
However, while debt being bad is at least partially true, there are many instances when using debt would benefit an individual or a group of individuals. Here are some occasions that may warrant you the use of debt:
Purchasing a home
The modern economy around the globe has made certain that most of us will not be able to save up enough cash in order to buy a home. Quite simply, the value of property is already very high in most places, and it grows much faster than you’ll be able to save up. However, most of us want to own a home before we’re old and grey. Taking out a mortgage is the simplest way to obtain a home sooner.
While you’ll not exactly own the property until you’ve actually repaid the full amount of the loan, using this method can help you make the purchase at a current price as opposed to much later, when the price of said property could be doubled, tripled or even worse.
Starting or maintaining a business
Let’s be honest here – even the best of ideas are not sufficient to succeed in business. Best ideas, however, find it much easier to attract investments. What can you do if you only have a good idea that most or all investors have simply overlooked. Or you’re unable to reach out to investors, period. Or what can you do if you’re already well on your way to reaching your goal but suddenly find yourself in need of additional funds to expand your business or manage over an unexpected ‘speed bump’.
Taking out a loan may be your only choice to keep on the same trajectory, or sometimes even to keep the business afloat. So, essentially, in order to keep making money, you need to borrow money.
Unfortunately, not all of us have been so lucky to reside in countries that offer high quality education free of charge. In some parts, getting that coveted degree can cost you an arm and a leg. Not literally, but you get the gist.
Getting that degree, however, can help you attain a higher earning potential than you would otherwise be able to. Therefore, while paying tens of thousands in loans for education may initially seem like a bad idea, it can potentially reward you tenfold or more long term.
Investing or debt leveraging
For those of you who have just started building your investment portfolio or are only thinking of trying in the future – using debt as an investment tactic may not seem as familiar. Indeed, this method is not for beginners and the faint of heart. Simply put, debt leveraging means borrowing assets in order to increase potential returns.
For example, you – an investor – have access to a margin account with your brokerage firm. A margin account allows you to borrow funds from said brokerage firm in order to invest. If your investment grows in value before the due date of your loan, you will earn money. Conversely, you will lose money if the value of your investment goes down before the due date.
Any debt that’s used on depreciating assets, is a bad debt. However, experienced investors know how to use this tool in order to grow their earning potential. If you research it thoroughly, perhaps it may suit you, too.
Reducing your overall debt
As we’ve established in previous articles, a debt is the sum of the principal amount and interest. If you’ve managed to acquire multiple sources of debt that each carry different interest rates, you might benefit from looking into debt consolidation.
Debt consolidation is effectively taking out a loan in order to repay all your other loans. Doing this can help you reduce the APR/interest you pay currently, especially if some of your debt is credit card debt, personal loans and other debt with high interest rates. This, in turn, can help you repay all your debts much quicker and be well on your way to increase your wealth.
What about bad debt, then?
As mentioned previously, any debt used on depreciating assets is bad debt. Of course, there are many depreciating assets that you need and use throughout your life. But, for the sake of your account balance! Don’t use debt to cover these expenses as far as practicable.
Food, rent, clothing, entertainment are just some of the aforementioned. Naturally, you can’t survive without food, shelter and clothing. Not for long, anyway. But, if you do have to use a credit card to obtain these things, try and make sure you always repay the full balance in order to avoid paying interest.
Similarly, if you need to purchase a vehicle, do so with cash or try to find the lowest-interest loan possible. A car will start losing its value as soon as it’s driven off the factory line. So in order to lose as little money as possible, you need to pay as little interest as possible. Or avoid it all together.
Debt is NOT like a box of chocolates – pay attention and you’ll always know what to expect and how to make the best of any situation,
This is an informative blog entry and should not be taken as financial advice.