What you’re about to learn here today is the difference between good vs bad debt. Our definitions are coming from an entrepreneurial standpoint. A lot of entrepreneurs will avoid writing an article on this, just like they’d avoid writing an article on assets and liabilities. The reason for this is because they’re scared of offending people or hurting someone’s feelings. If you want to be in that top 0.9% of millionaires on this planet, you need to change your perspective on good and bad debt.
Table of contents
What is good debt?
- We want you to think of good debt as an investment. To put it in very simple terms, good debt will increase your wealth and put money in your pocket.
Good and bad debt are very similar. Such as a credit card can be used for good, or for bad debt. As long as you always remember that if it doesn’t grow your wealth, it’s bad debt. For example, if you get a credit card and decide you deserve the newest BMW because you’ve “worked hard”, this is bad debt because it’s only going to take money out of your bank. If you use it to put a deposit down on a house that you plan to RENT out, this is good debt because you’ll get a return on your investment.
Examples of good debt:
- Mortgage: If you get a mortgage on a house that you plan to rent out or sell for a profit, then this is good debt. If you get a mortgage on a house that you want to live in for 30 years, to finally pay off but then keep having to pay utility bills, this is bad debt. To answer any smart replies to this statement, have a look at which one grows your bank. If you rent the property out, your loan is being paid off for you by the tenant, and at the end of it, you’ve got the property which you can then sell or continue to rent out.
- Student loan: A student loan, just like most other debts can be either good or bad. If you wish to get a high paying job but you have to go to University to get there, then a student loan may be for you. For most people, a student loan most definitely isn’t for them since they spend most of their life paying it off. I’d only ever recommend getting a student loan if you wanted to be a doctor, lawyer, or something of that nature because then that loan works as an investment for the future.
- Business investment: A loan which you wish to invest in your own business with can also be good debt. If you have a reasonable business plan with a low-risk, taking out a loan might not be a bad idea. A lot of businesses usually receive investments from shareholders, banks, etc who they pay back over time. This is a win-win for both parties involved.
What is bad debt
- Bad debt is a debt you have to pay off, but get no return out of it. If it doesn’t increase in value or generate income, then it’s bad debt.
Many people get into bad debt and try to justify it. Such as buying a nice car to “get them to work” when a bus or a cheaper car will do that exact thing. This is fine if you want to justify it, but I hope you’re having fun in the 99.1% category. If you can afford to buy nice cars and nice houses without taking a financial hit, then you probably already know the difference between good and bad debt, unless you received an inheritance. But I’m assuming since you’re reading this, you’re here to learn and hopefully use it to your advantage.
Example’s of bad debt
- Unnecessary luxuries: Unnecessary luxuries don’t just mean an expensive Rolex or suit, we’re talking about buying clothes you don’t need, Starbucks coffee, an upgraded car, a new desk. You get the hint. Like I said previously if you can afford it, then go ahead. But if you have to get into any form of debt to purchase “unnecessary luxuries”, then you’re only affecting yourself. Only you truly know if you’re about to make a necessary purchase or not. Before you buy it on credit ask yourself “what would life be like if I didn’t buy this”.
- Student loans: Why are student loans classed as good and bad debt you might ask? Well, I’ll break it down for you as simply as possible. If you take out a £100,000 (example) university LOAN to become a doctor and end up opening a small business selling trainers, you’ve literally just wasted years of your life and £100,000. Student loans just had to go in both categories since so many people waste away their time, their money, as well as their degree.
- Payday loans: I’m also going to mention payday loans here today. If you’re in debt, your last option should be to borrow more money to pay off that debt. This is not fixing the problem, it’s only moving it. Payday loans can charge up to 300% interest. So whatever you loan from them, you’re paying it back but 3x the amount. Yeah, you’ve just managed to pay off your £500 loan, but next week you’re paying back £1500. The worst part about payday loans is they don’t usually care about your credit score, they’ll give them to anyone.
What to consider about good debt
There’s always a risk when taking out a loan whether it’s for good or bad debt, but there aren’t really any other ways to get the money you need within a short space of time. This is why most entrepreneurs will advise you to “take risks”. We’d personally advise you to take “Smart Risks”. Here are a few things you should consider when taking out “good debts”.
Is your plan reliable?
When you are thinking about taking out some form of debt to make a profit, you need to plan it all out covering all corners because, in a worst-case scenario, you’re left paying off the initial debt, as well as the debt accumulated from the failed plan. So to avoid this, spend some time coming up with the best business plan possible, and when you’ve got it all planned out, plan out what you’re going to do if that plan doesn’t work. This is what we mean by taking “smart risks”.
How much interest do I have to pay?
When taking out a loan, 9 times out of 10 you’ll have to pay interest. There are ways to lower the interest you pay, or in fact not pay any interest what so ever. One way to avoid paying interest is to use your credit card but arrange to have the FULL amount paid on the next direct debit date. This might only work when it comes to smaller payments, but it’s a debt with no interest. The best way to lower the interest on other types of loans is to scale your credit score. Credit scores play a big part in the interest you’ll have to pay because it’s an indicator if the loaner can trust you.
Can I put in some extra hours to avoid taking out a loan?
This should be the very first thing you consider when you want to take out a loan. Although for employees this only refers to smaller amounts of money, for business owners an extra couple hours a day for a few weeks can seriously make a difference. You can do a lot of the work yourself instead of paying employees to do it, you can get that big contract deal you’ve been looking for, etc. If you’re considering getting into some debt to keep you afloat, consider this first.
How much will this increase in value or generate a profit?
When you take out a loan to invest in property, a business, or something of this nature, you’re hoping for an increase in value or for it to bring in some revenue for you. For example, if you take out a loan to buy a property, you need to evaluate how much it will cost to renovate, how much the property costs, utility bills, repairs, etc to see if it’s actually worth getting into debt over. Even though you had the intentions of using this loan as a form of “good debt”, without proper evaluation, it can quickly turn into bad debt.
The good debt vs bad debt argument will never have the “right” answer. Entrepreneurs, employees, government officials, all have different definitions. To put it very simple from an entrepreneur’s viewpoint, good debt is more like an investment that will either generate you money or acquire something that will increase in value. Either way, you’re profiting. Bad debt is just the very opposite. Bad debt is something you have to pay off but doesn’t give any positive return. The reason good debt vs bad debt is such a complicated topic is that they’re just so similar. For example, if you purchase a property on a loan that you can’t afford, but you’re planning on selling the property for more than you bought it for, then this is good debt because you’ll make a return. But if you buy that exact same property, with that exact same loan, this is a form of bad debt because not only are you paying the bank a mortgage, but you’re paying utility bills to live there.