In today’s post we’re going to be talking about Good debt vs Bad debt and is there such a thing as good debt?
My whole blog is obviously about helping you master your money, build your wealth, and get you out of Consumer Debt. However, I am a believer that there is good debt and I’ll explain why in this post.
Their absolutely is good debt and bad debt. Leverage is a tool when used properly and responsibly it gets you to where you want to go faster.
However, in this post, I do want to establish my thoughts about good debt and bad debt and give you a few real examples of good debt and how you can use it.
What is Good Debt?
Good Debt is basically, in my eyes, something that helps increase your wealth over time. This could be the purchase of a property whether it’s income-producing or it could even be your own residence which appreciates over time with value.
Also, it’s something that throws off value periodically. Whether this is a monthly rental property that may bring in some money every month or an ATM business where you make money every month passively.
This is my definition: raises wealth over time or throws off some value.
What is Bad Debt?
Bad Debt is basically the exact opposite. This is something that lowers your wealth over time, it does not increase your wealth and it does not throw off value every month.
This would be something like a consumer purchase. Say you buy an iPad for example and you spend $500 on it, that money is gone. That thing’s not appreciating in value and it’s not throwing off any money.
If you use debt (a credit card) to purchase an iPad that would be bad debt.
Some examples of Good Debt vs Bad Debt
Small business loan
This is a real-life example I found online. There’s a gentleman whose father owns a small business that he eventually took over. He said:
My father had this mindset “Pay for everything in cash safe first and no debt” Our family business desperately needed new equipment but my dad refused to finance it and wanted to save up for it first.
When I took over I bought all the equipment we needed and had about $25,000 a year in debt payments. This is known as Debt Service. Then that increases our revenue by $250,000 which is basically a 10 x return on investment.
There’s absolutely good debt and bad debt. My dad would still be saving for that equipment but instead, we’re earning money off of it every day.
What do we take from this example?
Small business loans have multiple benefits.
They help you scale your business. As mentioned in the example this gentleman basically 10X his business’s revenue off of that debt he took. He’s paying $25k a year and making $250k back.
The second benefit is that you don’t give equity in the company. Instead of him having to give up equity in order to expand, he just took a loan to scale his business and didn’t give any shares of his business.
This is a huge benefit because every entrepreneur knows that giving up equity in your business is probably not the route to go especially if it’s something that you nurtured from its infancy.
Also, the interest on that loan is tax-deductible. It’s a business expense you can write off taxes.
The second example is about student loans
Let’s say a nurse taking out loans to become a nurse practitioner. Loans may be at $90,000 at most to make $100,000 a year in income, basically doubling their income every year once they’re done.
In my personal opinion, I would consider this good debt. If you know that you can double your income by basically taking out ‘x’ amount of dollars in student loans it makes all the sense in the world.
Let’s say that my wife’s further education, her master’s degree for a nurse practitioner is going to cost basically $27,000 total and her salary is essentially going to double. Now, if you take that over the course of a lifetime the ROI on that is going to be exponentially higher than what the debt was.
She can essentially just pay this off after a year of becoming a full-time nurse practitioner.
In my opinion, student loans depend on what you study. You can’t go to college to become an underwater basket weaver or Arts major and consider taking student loans as good debt.
You can learn all that stuff at the library or on YouTube to be quite honest.
So if you’re going to go this route you need to study something like science, technology, engineering, or mathematics. These are the degrees that have a high ROI (return-on-investment).
The third example of good debt is the thing that created the most millionaires throughout history and that’s Real Estate.
You can leverage debt to buy rental properties. Again, debt is a tool.
You need to understand what we call Cash on cash return. It’s basically one of the biggest or the quickest metrics that you can see if a real estate investment is worth it or not.
We’re going to take our pre-tax cash flow and divide it by the annual income that the property produces.
Let’s take a property that effectively grosses $180,000 a year. This is what we bring in as income minus the operating expenses of $70,000 a year which brings us to $110,000. Also, this investment to buy, Straight Cash for the people that are anti-debt, is $1,000,000. This is a $1,000,000 commercial real estate property.
If you take the pre-tax income divided by the annual cash flow this gives us a Cash on Cash return of 11%.
Now, let’s use the same exact example and we’re actually going to finance this with the good debt that we’re talking about. So we have the same net operating income except that we’re going to finance $800,000 because we’ll put 20% down. Our mortgage is $800,000 and we’re using $200,000 of our own money.
Now, net income was $110,000 minus The Debt Service (debt service is basically just the cost of your interest). So a $800,000 loan at 8% cost $64,000.
$110,000 – $64,000 = $46,000
You get $46,000 and divide it by how much money do we have into this deal ($200,000). Remember we’re using $800,000 of the bank’s money. This comes out to be 23% cash on cash return. We’re doubling our effective cash on cash return.
This is what we would consider good debt.
Examples of bad debt
Bad debt is pretty much common sense.
Credit card debt
Credit card debt is dumb. It’s usually used for things that you can’t afford in the first place. Sometimes they’re used for emergencies but most times they’re used for stupid impulse spending.
That typically comes from Consumer Debt. This is the stuff that you make impulse purchases on and don’t necessarily need.
Typically when people talk about cars and car loans they’re talking about A2B Transportation. You’re getting them to and from work..etc.
However, if you take out a car loan even if you can get 0.5% it’s still bad debt because thinking about our definition, it’s not raising your wealth and it’s not throwing off any money.
If it doesn’t increase your wealth or bring you money it’s not good debt.
Thanks for your time
This was my approach to Good debt vs Bad debt. I hope you liked it and if you did then I recommend you to join my newsletter I post about money management and how to make money online.
Also, if you think this post might be helpful for others, feel free to share it.