What is Good Debt?

People tend to lump debt into one category: bad.

But not all debt is created equal; there's actually good debt and bad debt. Debt is actually something that you can use strategically to help yourself advance.

So, really simply, let's talk about the difference between good debt and bad debt.

What is Good Debt vs Bad Debt?

Good debt is debt that you take on strategically to help yourself increase your financial position, whereas bad debt is debt that you take on non-strategically that hurts your financial position.

Have you ever heard the term “leverage” be used to describe debt?

Leverage is when you use borrowed capital for an investment and you expect the profits made to be greater than the interest that you pay, meaning you are borrowing money from someone else so that you can take advantage of an opportunity or make an investment that is going to return back to you more money than it cost you to go and pursue that opportunity, including the interest you had to pay on the debt.

Examples of Good Debt: Student Loans

Here's a really easy example of using leverage: if you went ahead and went to university and got a degree that increased your earning potential, but you had to take on student debt in order to finance that degree.

That's an example of using leverage (student debt) to make an investment in yourself and your education that produced a return where hopefully you are now earning more than you owe on that debt and the interest payments.

That's an example of good debt. It's debt that you are strategically using to enhance your financial position.

Examples of Good Debt: Mortgages

Some other examples of good debt could include buying a home and using a mortgage, depending on the interest rate that you qualify for. If you have a low interest rate on your mortgage and you're now able to lock in the cost of living for your home, so you are no longer going to be paying rent and be subject to inflation, you have a fixed cost that's locked in, and if that rate is low enough and you didn't overborrow and take on a bigger mortgage or buy a bigger home than you really can afford.

That can be another way of strategically using debt to advance your financial position as you build up equity in your home and you secure your cost of living.

Examples of Good Debt: Business Loans

Another example of good debt can be taking on a business loan.

You may take on a business loan to start a business, or you may take on a business loan to expand a business.

Let’s say you need to borrow someone else's capital to buy a big purchase of inventory when you know your customers are chomping at the bit and are going buy that inventory.

When Does Good Debt Become Bad Debt?

Problem 1: You Don’t Follow Through

One of my favorite types of good debt is when you are making an investment in yourself and your education to build skills that are going to increase your ability to earn income.

But what's most important when taking on good debt is to make sure it stays good debt and doesn’t become bad debt.

To keep debt from turning bad, you need to make sure that you actually get the return on the investment.

For example, let’s say you get a college degree and you got student loan financing to pay for it. But then when you graduate, you decide you don't like that work anymore, and you don't want to use your college degree. You can end up in a situation where you didn't actually get the return on that investment because you paid this money to get that degree so that you could increase your earning potential and now you're not taking advantage of it.

That's one example of how good debt can become not-so-good in the end if you don't actually follow all the way through and get the return on the investment that you were expecting.

Problem 2: The Return on Investment is Low

When taking on new debt, you also really want to think about that return on the investment that you can expect.

You could also face a situation where perhaps the cost of the education or the the training that you are considering is outsized for the return it's actually going to give.

For instance, there are some degrees out there that are costly but do not increase your earning potential enough to give you a positive return on your investment.

How to Avoid Bad Debt

When you’re taking on debt, you want to think strategically and ask yourself these questions:

• How does this help me get ahead?
• Am I confident I'll be able to produce a positive return on this investment if I strategically take on debt to finance this?

Now let's switch gears and talk about bad debt.

What is Bad Debt?

To clarify, bad debt is different from good debt that's gone bad. It was just bad from the beginning. Bad debt is when you borrow money to purchase something that does not increase in value over time.

It's when you're buying consumables and using other people's money to finance them.

For example, if you are paying for a vacation on a credit card, that's bad debt. The value of your vacation, while it creates a lovely life experience, does not increase in value. After you've had the vacation, the value of it is completely gone, but now you are still paying for it. Worse, you're paying interest on it.

Pretty much any debt that we take on in order to buy a consumer good is going to be bad debt.

Of course, sometimes it's unavoidable and if you are in financial debt right now, I highly recommend you take our 5 Days to Debt Free training class.

How to Manage Your Debt

Debt can be a complex topic and it's normal to have an emotional reaction to debt.

Some people are comfortable with debt and know how to use it strategically, and other people want nothing to do with debt no matter what. Either approach is okay.

But understanding the differences between how you use debt strategically (good debt) and how you use debt to your detriment (bad debt) can help you make the right financing choices when you're faced with important financial decisions.

If you want to learn more about how to kickstart your journey to financial wellness, then check out our free investing masterclass!

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