When searching the internet for financial advice, one thing that pops up time and time again is, “ALL DEBT IS BAD.” This is one of the many financial advice clichés that everyone follows and it couldn’t be further from the truth. Contrary to popular belief, good debt does exist! In this post, I will show how you can use debt to reach and accomplish all of your financial goals.
Knowledge is power but not all knowledge is created equal
The Purpose of Debt
Debt is any money taken on loan from a bank, individual, or state. Debt has a purpose; which is used to stretch your purchasing power further than if you only used cash. In our economy, we can attribute the fast economic growth to debt (credit) but we can also attribute those fast economic declines (crashes) to debt as well. Debt allows companies to expand and grow extremely faster than they would with just cash. This allows them to hire more people and that alone has a domino effect on their products and production. This makes it easier, faster, and cheaper to get their product to every single person in the US. However, some companies take on too much debt and during the down end of their business cycle, it could push the company into bankruptcy and they might even be forced into shutting down forever.
Without debt, there would not be any of the things which we enjoy every single day. Our technology would not be as advanced, or any of other things which feed on the success of the economy such as the advancement of medicine. Our standard of living would be much worse. Things which are considered a need: heating and air conditioning may not be as universal as it is now. What we consider as basic needs could be only for the rich and powerful.
As you can see debt is very powerful. It may be used to build and expand on things like companies and neighborhoods. But if used irresponsibly it can be used to destroy that which it set out to build. You must understand good debt vs bad debt if you want to be successful financially.
Good Debt vs Bad Debt
How do you know if the debt you are taking on is good debt? If debt is used to purchase an asset (anything that increases your income) then its good debt. If debt is used to purchase liabilities (something that takes money from you) then it is no longer good debt. However, this is not set in stone all of the time.
An asset is anything which provides income. Debt which you take on to get a higher education which increases your income is considered an asset. If debt is taken on to buy a second factory to increase production of your business that is also good debt. Taking out a loan to expand your business and hire more employees to increase production is good debt. Basically, any debt taken on that provides you with more production or revenue can be considered good debt.
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Warning: With this, you have to be careful and smart with your money. A $30,000 debt for a degree which has low income and very low job availability is not smart and therefore that would be considered a liability and not an asset.
A single-family home IS NOT AN ASSET! It is not considered an asset because many expenses are expected such as roof, plumbing, etc. If you live in the house then you are paying the mortgage which means you are losing money and no asset takes money away. If you are renting it and the one tenant leaves then you are losing money right away. In no circumstance is a single family home an asset. The “equity” that you are putting into your house is nothing more than a forced savings account. There are many other options out there that can get you better returns on your money than that forced savings account.
Too much good debt could also lead to a disaster. A business owner could have taken on a too much good debt that has been used in a way to increase revenue for the company. All of a sudden, an economic downturn begins and people aren’t buying your product as much. Now you can’t pay off your debt payments and are forced to declare bankruptcy and your company just might go under.
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A liability, if you haven’t figured it out yet, is anything which either depreciates in value or takes money from you. A car is a good example of a liability because it loses value every day and costs you to own every month.
Exception: However, sometimes it is actually recommended to purchase liabilities with debt if that means you get to keep more cash now which you can then use to increase your income. Let’s say, you are making $600k a year and you want a new Mercedes worth $100k that you have the cash for. It’s better to take a $750 a month expense with a small deposit and keep at least $90k. Then you should use the $90k money to help increase your income to $1M a year. Sometimes it can be a good thing to buy a liability with debt but more often than not it is a bad decision to do so. Consult with a financial advisor before taking on debt for any asset or liability.
Debt is a very powerful tool but if used too much even for the right reasons it could destroy you. Be smart. Change the way you think of money and use what others avoid to get yourself to financial freedom.