The Difference Between Bad Debt and Good Debt

A common mistake many people make is to think that all debt is bad. That is not true. The richest people in the world did not become that way by avoiding all debt. They made their money by knowing which kinds of debt were good and which were bad. Unless you learn the difference between good debt and bad debt you will be stuck in the rat race, struggling to make ends meet, for the rest of your life.

Assets and Liabilities

The first step is to learn the difference between an asset and a liability. Once you have learned this, everything else will fall into place. The problem arises when people think that something is an asset when, in truth, it is actually a liability.

It is not surprising that most people are not clear about these definitions. Just look the words up in the dictionary. Unless you are a trained accountant or financial planner, you will probably be more confused than you were before you read the explanations. In truth, the definitions are so simple that people have problems accepting them.

We have been conditioned to believe that things like our home, a car, a boat and similar items are assets. Banks contribute to this myth by allowing us to list these items under the assets category on our financial statements. What makes this common assumption wrong? It comes down to one simple premise.

An asset makes money for you; a liability costs you money.

It almost sounds too simple to be true. However, once you stop and think about it, it makes perfect sense.

Example of a Liability

You buy a car for personal use. If you are the typical buyer, you buy it on credit, incurring a monthly payment. This costs you additional money in the form of interest. Even if you pay cash for it, it still costs you money on an ongoing basis. You must pay monthly or annual premiums for insurance. You must purchase gas and oil regularly. You must perform maintenance on it to keep it in running order. Never does it pay you.

That is not to say that you shouldn’t buy a car. Like every other buying decision, the advantages and disadvantages must be weighed. Having your own vehicle can be cheaper than paying for a bus or cab or other public transportation over a period of time. It can allow you to accept a job in a location not served by public transportation. A car can enable you to take your family on an inexpensive vacation or on a quick trip to the beach.
But it isn’t an asset. It isn’t making you money. Therefore, you should avoid going into debt to purchase a vehicle. It falls into the category of bad debt.

More Bad Debt

An even worse example of bad debt is when you borrow money to buy “toys” such as a boat. In addition to costing you interest, a boat loses value with each passing month. It also costs you money in the same way a car does – insurance, fuel and maintenance.

A big-screen TV or an expensive trip may not cost you additional money after the initial purchase. However, they do not make you any money. Their only redeeming quality is that they provide temporary pleasure. You should be fairly sure about your current and future financial position before you purchase something like this using debt.

Good debt

Good debt is when you take on a debt to buy assets. As we said before, an asset is something that makes you money. This can come in many forms.

Example of an Asset

An excellent example is rental property. You find a property, get a mortgage on it and rent it out. If you have done your homework properly, after the mortgage and all of the other expenses are paid, there will be money left over. This is called income. This, along with the reduction of principal owed, increases your net worth each and every month.

Other Types of Good Debt

There are other cases where going into debt is a good thing. One of them is when you buy a profitable business. A good business will not only give you income after the expenses are paid, it will also grow in value over the years.

Another example of good debt is when you purchase a class or a course that enables you to earn more money than you were earning previously. This is called investing in yourself. When all is said and done, your biggest asset is you.

Summary

In conclusion, good debt is when you buy assets. Bad debt happens when you buy liabilities. The people who become rich are the ones who learn this and put it into action.

You can learn the difference between good debt and bad debt and begin living your dream. Or, you can ignore this lesson and risk turning your life into a financial nightmare.

Do not take this too seriously, but before you get into debt to buy that big “toy” you might want to think about making sure that you have some assets and income as well.

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