(good debt vs bad debt – 5 minute read)
Hi there accounting fans!
Regular readers of this blog will know that we have a strong ‘anti-credit’ stance in this blog. However, I should point out that we don’t believe that ALL debt is bad and that some debt can be good. The important thing is to know the difference between good debt and bad debt. Let’s start with the basics:
What is debt?
Debt, also known in accountingese as ‘liabilities’ are funds that you owe to other entities. Borrow money from the bank to buy your first home – debt. Get goods from your supplier and pay them later – debt. Paying your staff in the new year instead of before Christmas for work done in December – also debt.
When running a business, there are many examples of small debts that we pick up while operating the business. Hence why in accounting, we differentiate between current liabilities (which are small and paid off quickly) and non- current liabilities (which tend to be larger and paid off over a period of time).
But I digress, lets’ talk about good and bad debt.
What is Good Debt?
Good debt is debt that makes you more money. Good debt is debt that is taken on for investments that have the potential to increase in value or generate income.
For example, you take out a mortgage to buy your first home. Over time, the property value increases, you save money on rent and once you have paid it off, you have the potential to rent it out yourself. Hence the debt you incurred was good because it has put you in a better financial position than you were before.
A simpler example would be to take a loan at a 4% interest rate (good luck finding that!) and invest it in a guaranteed fixed return investment of 7% (again, I don’t actually think it exists, but just bear with me). This means that you are making sweet ‘arbitrage’ (finance douche-bro code for ‘profit’) of 3% on your loan.
I could give other examples, but you get the idea. So long as you have a plan to use the loan to generate more wealth (financial and otherwise) for yourself, then it is a good debt. So now let’s talk about:
What is Bad Debt?
Bad debt is the opposite of Good debt. Bad debt is debt that is taken on for items that do not have the potential to increase in value or generate income. The simplest example is getting a credit card, or one of those ‘pay-later’ companies that charge you if you miss on their ‘interest free’ payments to buy stuff that you don’t really need.
One of the most egregious examples of bad debt is taking a loan on luxury cars. I have nothing against luxury cars. If that’s what you like, go for it. But be smart about it. Don’t be taking loans on things that you don’t need. A second hand 2005 Toyota Wish will get you from point A to B as effectively as a brand new Tesla Model Y. Also, you won’t be paying a ton of interest in getting the second hand car. If you want a luxury car, save up for it. Don’t be taking a loan on it!
Understanding the difference between good and bad
So, to keep it simple, here are some tips for maximising good debt and reducing bad debt:
- Use credit wisely: If you’re going to use credit, make sure it’s for purchases that have the potential to increase in value or generate income. Avoid using credit for non-essential expenses or items that are likely to lose value quickly.
- Shop around for the best rates: If you’re considering taking on debt, shop around to find the best interest rates and terms. This can help you save money in the long run.
- Pay off high-interest debt first: If you have multiple sources of debt, prioritize paying off the debts with the highest interest rates first. This will help you save money on interest and pay off your debts faster.
Debt is an ever-present part of life. So be smart about how you use it. In the meantime,
Stay positive!