Do you want to reduce debt? I am sure you have heard about debt consolidation and debt reduction programs. But before you rush into getting rid of debt or acquire new debt. It is worthwhile to understand the difference in Good Debt vs. Bad Debt – ever wondered why some debts are better than others.
Let me tell you a story. A few years ago I met this woman who was in her 50s and had a good stable job. This job paid a low six-figure salary but she lived out of her car. When I asked her why she lives out of her car? She responded, “I can’t afford the rent“. Let me also tell you this was in the mid-western US where the cost of living is relatively low. I just couldn’t understand how she is not able to afford. So I decided to meet her again and ask her more questions.
What I learned from this exercise? When she was young she kept on piling debt – credit card balances, personal loans, auto loans, HELOCs, etc. Now she was neck deep into the debt hell that after making debt payments she has barely any money left. Hence she had no other choice but to live out of her car. Having a high salary is not enough for financial independence. In this post, we will try to understand how debt can make or break your bank.
Think Hard Before You Get a New Credit
Whether you want that new shiny car, or a new credit card, or getting drowned in debt. I want you to stop and think and think again. Before you pile on the new debt it is wise to understand the following:
Will the new debt will help you reach your financial goals faster or will drag my goals down. Always ask yourself is this good debt vs. bad debt. You should almost never acquire bad debt. There are people on two extremes. One who steers away from all kinds of debt and others who will keep piling on debt without realizing they are digging a debt grave for themselves.
But a financial Independence, Early retirement seeker should be somewhere in middle. You should be using debt to your advantage.
My take is good debt can be a fantastic leveraging tool that can accelerate your progress towards financial freedom. However, realizing which debt is good and which is not is a foundation stone. So without further ado lets jump right in.
What is Good Debt? (Mortgages and Student Loans)
The good debt is the one that accelerates your journey to passive income, financial freedom or early retirement. Some examples of good debt are – mortgages, student loans, margin trading, etc.
Mortgage – Good Debt when used wisely
When you get a mortgage to buy a house it is sort of good debt. Why? Because a mortgage enables you to buy an appreciating asset by putting down a fraction of the price (20% or less) down and borrowing the rest. This phenomenon is called leveraging and when used right it can help you accelerate your passive income. Let’s work with an example to make sure we understand this concept in its entirety. Say you have $100K available to invest and you have the following three choices available:
- Invest $100K in stock market
- Buy a house worth $100K and rent it out
- Buy 5 houses worth $100K each and putting down $20K down and borrowing $80K each.
If you look closely and think about it a bit you’ll realize that Option 3 might not be as cashflow positive in the beginning but over time your income will grow much faster as the mortgage has allowed you to buy $500K worth of assets by just putting down $100K. For this reason, I think Mortgage is a Good Debt and if used wisely can really help you accelerate your passive income and achieve financial freedom.
Student Loans – Good Debt if careful
When you get a student loan to improve your educational qualification which will help you increase your income it is a really good investment and a worthwhile debt to consider but if you get a student loan to go to school but are not sure if this education will help you increase your income then you should reconsider your plans. Think of all college kids graduating with tens or even hundreds of thousands of dollars student loans.
What would they have done if they didn’t want to take on Student loan to go through college they would not be able to make the kind of money they can make with the college degree, think about doctors, lawyers, computer programmers, MBAs. Most of them come out of college with a pile of debt and many of them actually cash in on the opportunity and get debt free really fast with discipline as well.
What is Bad Debt?
Bad debt is the one that doesn’t help you accelerate or rather becomes an obstacle in generating passive income or keeps increasing liability. Some of the examples are credit card balance, personal loans, auto loans, pay-day loans, etc.
High-Interest Credit Card
Credit card balances are one of the worst debts to have. While using a credit card for your purchases can be really beneficial but it is very easy to fall into the trap of impulsive buying or buying things that you can’t afford and once you fall in the trap it is really hard to come out because of the high-interest rates and the debt keeps climbing up and up. My advice is to avoid credit card balances as much as you can. If you must carry a balance on your card you should build a plan to pay it as fast as you can or consolidate it into a personal loan.
Have a credit card debt – You should work to reduce debt asap.
Personal loans are also evil but a necessary evil. If you carry a balance on multiple credit cards or have multiple bad debts I recommend you try and consolidate them into a personal loan so you can make a single payment and work your way up to becoming debt-free.
Pay-day loans are the worst types of debt and you should steer away from them at all costs. If you really need the money before your paycheck you should try to get advance from work, ask family or friends for help and return the favor as soon as the paycheck hits your bank.
Conclusion – Good Debt vs. Bad Debt
Good debt vs. bad debt is a very subjective topic and I know there are several other types of debts but you now get the idea on how to evaluate the debt and decide if it is good for you or not. If you can take one thing from this long post I want you to take this – Before you get the new debt, ask yourself one question – If I take this new debt how will it affect my financial goals and then decide if you really want to take on the new debt.
Share your suggestions and criticism via comments.