We all have to borrow money to get ahead in life… there’s no escaping it. It’s important when borrowing money (taking on debt) that you understand the difference between “good debt” and “bad debt”
Until we are independently wealthy, we all have to borrow money to get ahead in life… there’s no escaping it. It’s important when borrowing money (taking on debt) that you understand the difference between “good debt” and “bad debt” and try to avoid bad debt.
Bad debt is borrowing money for something that depreciates (becomes less valuable) over time. Most purchases fall into this category. Think about the following: automobile, television, computer. Each of these things is instantly worthless when you buy them and with time they are always worth less and less. You should plan to not buy these items on borrowed money. If you purchase bad debt items with borrowed money, you always lose. Here’s how:
- You are acquiring an item that immediately loses value and gets worse over time. You’ll never get that money back. If you fall on hard times, you cannot hope to sell this item and pay off the debt because the sale price is always less than the item.
- You have to pay interest on the borrowed money. Interest is always sunk money that you’ll never get back.
It just doesn’t make sense to borrow money for bad debt items. Now, sometimes bad debt will be forced, but as much as possible avoid it like the plague. This means really differentiating between wants and needs and waiting for the wants until you have enough money saved to pay cash for these items when you determine you can afford it. Then, at least you are not accumulating interest on borrowed money and there is no risk of being left with debt if hard times come.
Good debt, on the other hand, is borrowing money for something that appreciates (becomes more valuable with time or improvement). Examples of this are property, education and fine art. Typically these items will be more valuable if you try to sell them in the future. You sell your education by applying it to a job in return for money. You typically sell a house for more than you paid for it. Debt is good whenever the value of the thing you paid for or borrowed money for increases with time. On top of that, the appreciation of the item should be greater than the interest incurred for borrowing the money. For example, if you buy a house for $250,000 at an interest rate of 7%, and you find that the house value is appreciating at a rate of 10%/year, that’s great! However, if you find that the value of the house is growing only at say, 3%, then your “good debt” isn’t so good after all. You are still net for losing money. Now, that’s still better than bad debt because if needed you can sell that house and pay off the debt, but its definitely not ideal.
So, the moral of the story is… borrow money for good debt, but not for bad debt. When you have to incur bad debt, plan to (whenever possible) save the money and pay with cash. Of course, this may be difficult for big-ticket items like a car, but be careful to distinguish between needs and wants. You should never buy the big screen TV on credit. Bad, bad bad. More on needs vs wants next time.