Contrary to popular belief, debt is good.
Have you ever heard the phrase « Debt is bad »?
It’s arguably one of the most repeated mantras in the personal finance space.
However, the truth is quite different.
In fact, some debt is good – very good in fact.
1. What is Debt?
Debt is something – generally money – that is borrowed by one party from another party.
For example, I can ask my friend Max to lend me $10. If he agrees, he gives me a $10 bill and I promise to pay him back as soon as I can.
In the real world, people borrow money from financial institutions called banks.
Banks specialize in lending money to individuals and businesses.
However, they aren’t as easy to deal with as my friend Max.
Virtually all banks will charge you a fee in exchange for their loan.
This fee is called the interest.
The rate of interest depends on many factors, but it is almost always higher than 0%.
Unfortunately, very few people can borrow money for free.
Thus, the vast majority of us has to pay the bank to borrow money.
2. What is “Bad Debt”?
When personal finance experts talk about debt, they usually about it negatively.
One of their favorite mantras is: “don’t get into debt!”
To their credit (no pun intended), they are usually referring to the bogeymen that are credit cards and “fast-cash” loan agencies.
While these types of debts are usually considered “bad debt”, they do have some advantages:
- Credit cards help you build up your credit score and get access to bigger loans down the line
- Fast-cash and payday loan services provide easy access to liquidity during hard times.
The issue with these types of debt is the penalty incurred for late payments.
If you miss a credit card payment, the interest rate can shoot up to 20% or more.
If you fail to pay back your fast-cash loan on time, interest rates can rise much higher than that.
Thus, these debts are indeed “bad” if you’re unable to respect the payment terms.
However, that’s enough about bad debt.
Enough people have written about it.
That’s why I want to talk about “Good Debt”.
3. Debt is Good
It’s important to set the record straight: there is plenty of “good debt”.
As mentioned earlier, credit card debt is good if you’re trying to build up your credit score and able to pay on time.
But that’s not really “good” debt. It can be categorized as “average” debt.
The best type of debt is what sophisticated investors call “leverage”.
Leverage is the act of borrowing money to invest in an asset that will generate significant returns on investment.
Imagine this: you give the bank $10K and it loans you enough money to buy a $100K house.
Sounds like a good deal, correct?
Well, this deal exists: it’s called a mortgage.
Real Estate investors know that debt – or “leverage” – is an amazing wealth generator.
That’s why they borrow money to buy real estate even if they are able to buy the property cash.
Why spend $100K when you can buy it simply by giving the bank $10K?
Here’s the financial breakdown of why this is good debt:
- If you buy the property with a $10K deposit and rent it for $500 a month, you’ll get your money back in just 20 months.
- If you buy it cash for $100K, it will take 200 months (16 years!) to recoup your investment.
Which scenario do you prefer?
4. How to Use Leverage
Leverage can thus be considered “good debt”.
However, it’s also a double edged sword.
These days, you can use leverage to buy almost anything.
Some investors use leverage to buy relatively safe assets, such as houses and apartment buildings. Others use leverage to buy risky assets like penny stocks and call options.
As you can imagine, the former is a better use of leverage than the latter.
It’s your responsibility to invest in assets that present a favorable risk-reward proposition.
Keep in mind that leverage works both ways: if your investment loses value, you’ll be deep in the red and you will owe your financial institution big money.
This can lead to bankruptcy, divorce and even suicide.
Don’t let this happen to you.
Use leverage responsibly and never gamble money that isn’t yours.