What’s the difference between bad debt vs good debt?
Despite what our parents told us when we were growing up, debt is not necessarily bad.
Some types of debt can actually make us wealthy.
Then again, some types of debt can make us poor.
So, what is the difference between good debt and bad debt ? And what about the type of debt that has unfulfilled potential?
Not all debt is bad.
Nathan Birch is a property investor with more than 200 properties in his $50 million portfolio. He earns around $500,000 a year in passive income.
How did he achieve this?
It was a result of hard work, commitment to achieving his goals and being able to execute a well-researched and carefully planned strategy.
But, before he could do any of this, he had to change his mindset around debt.
“Like most people, I used to think debt was bad and that you should pay it back as soon as possible,” says Nathan.
“But when I thought about it, I realised that if I was to spend a good chunk of my life paying off a house, I would have one property that would have gone up in value.”
“If I had of focused on investing in good properties instead of paying back debt, I would have ended up with a whole heap of properties that had gone up in value instead.”
What is bad debt?
Bad debt is the sort of debt that comes from buying something that will only ever depreciate in value. The purchase doesn’t create an income and the loan tends to have a high interest rate attached.
You end up slaving away trying to pay it off. The longer you take to repay it, the higher the debt becomes.
The following types of debt are examples of bad debt:
- Credit card debt
- Personal loan debt
- Car loan debt.
What is good debt?
Debt can be thought of as “good” if you use it to buy an income producing asset that has the potential for strong capital growth.
An investment loan is the perfect example of good debt – as long as you buy a good property.
Not only does the value of the asset go up in line with inflation, rendering the debt irrelevant, it also produces an income through the form of rent. The rent you charge can be used to pay off the loan – meaning your tenants, and not you, are footing the bill for your property.
This is one way that you can put your money to work for you.
Good debt tends to have a much lower interest rate than bad debt, however, the overall size of the debt tends to be much higher.
When good debt isn’t as good as it could be.
If you have just purchased your first home, chances are you are both elated and somewhat overwhelmed. You probably face a lifetime of full-time work to repay the debt – all for the privilege of having a roof over your head.
While home loan debt is generally thought of as being good debt, it could be so much better.
It’s highly probable that your home will go up in value as you pay it off – but it won’t generate an income unless you rent it out or accept lodgers.
This is not an ideal situation. Instead of putting your money to work, you are working to pay off your asset – only to realise the capital gains you have made at the time of sale.
Then, when you do sell it, you need to find somewhere else to live. Unless you are downsizing, you aren’t likely to gain much from the transfer.
Not using debt to its full potential.
Another example of unfulfilled good debt is when you are under-leveraged.
You may have the ability to borrow more and invest in two or three properties, but you decide to invest a large deposit in just one. Instead of diversifying your debt across a few properties and gaining more through each market cycle, you only realise the gains from just one property.
You also only earn one rental stream instead of three, costing you thousands in opportunity costs.
When good debt turns bad.
The whole good debt versus bad debt thing is not a black and white consideration.
If you have used up all your servicing potential on a few properties that have since dropped in value, you will find it very hard to move forward with your investing. If they have a negative cashflow then you will find yourself over-leveraged and struggling to pay them back.
This is when good debt turns bad. You owe more in debt that the properties are worth and you can’t borrow more. They are costing you money each week and if you sell them, you will still be in debt.
Another example is when you buy a property that has a neutral or a positive cashflow but is in an area or a market with little renter demand. While the value of the property may go up in value, prolonged vacancies mean you aren’t earning much rent and end up paying back the debt with your income.
The money you put into these sorts of properties is money you could be investing better. Instead of footing your own debt bills, you could be saving up for another deposit.
Leveraging your debt just right.
Nathan believes we are entering into an economy in which inflation will make assets more valuable than money. As money loses value and property price and rents go up, debt will be irrelevant.
But this is only true of good debt. While inflated rents will enable investors to pay down old-world debt over a shorter amount of time, bad debt will only make it harder for borrowers to get ahead.
If you want to build wealth and reach financial freedom through investing, it is essential to leverage yourself in a smart way – not too much and not too little. This way you can use your borrowing power to maximise the number of good assets that you can comfortably hold, all while generating an income that will increase as time goes by.