Have you ever been heard the terms “good debt” and “bad debt“? When I was pursuing my finance degree, these terms were thrown around in nearly every class. We, as students, were being trained to be the future financial leaders of America, and in order to do so effectively, we needed to understand the difference between good debt and bad debt.
Debt in General
I’m sure we all know what debt is, but let’s review just to make sure we’re on the same page. When one borrows funds in order to attain an object or service, that person is in debt to the lender, often for more money than what was initially borrowed – this is due to the interest.
Unless you’re borrowing money from your mommy and daddy, chances are that you’re going to have to pay back your debts with interest. If you borrowed $100,000 at a 4.5% interest rate for 30 years, you would pay about $83,000 in interest! That means that you borrowed $100,000, but you ended up paying back $183,000 to settle the loan.
Most of the time, when someone borrows money to attain a depreciating asset, this is called “bad debt”.
The best example of bad debt is purchasing a brand new vehicle on credit. You’ll purchase your $20,000 car for $25,000 after 5 years, but at that time, it will only be worth about $7,000.
You see, the value of a car almost never goes up! Parts begin to wear and repairs become mandatory. The car slowly nears the end of it’s life and eventually becomes worthless. A possession like this should never be financed!
Obviously, good debt is the opposite of bad debt. When one borrows money and earns more with it than what they owe in interest, this is when debt is considered to be “good debt”.
In other words, let’s say someone decides to start a detailing business and borrows $10,000 in order to get all of the necessary supplies. If, after a few years, the business is valued at over $50,000 and the loan amount totalled to only $20,000 after interest, this investment would have been a considered a success and the debt would have been “good debt”.
My Take On Good Debt and Bad Debt
My wife and I both came out of school with college debt (which would techically be considered “good debt”). It didn’t seem like a big deal until the bills started coming in the mail and we didn’t have the cash flow to keep up with them. Rather than increasing our savings, every month was slowly eroding them.
In order to combat the debt repayment, we decided to drastically cut our spending and make every effort to make more money. Luckily, we were successful and didn’t default on any of our loans. In fact, by combating our debts head-on, we were able to pay off $24,000 worth of debt in 14 months!
Without debt, cash flow is easy. Large sums of money can be saved up in a matter or weeks and everything suddenly seems affordable without asking the bank for permission to use their money.
I don’t believe there is such a thing as good debt or bad debt. Debt is debt, and it increases the risk of financial disaster. Avoid debt and your savings will go up, while your stress level will go down. Business ventures will suddenly become easy and profit will soar through the roof. All because you avoided debt.
What is your take on good debt and bad debt? Do you agree with the terms? I’d love to hear your comments!
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.