Good debt, bad debt - is there a difference?

By Christopher Music

Do we really need debt?

Is debt actually something that is part and parcel of our economic existence?

Let’s take a look at what debt really is. It’s defined as one owing something to another or the condition of owing. Why do we get into a condition that we owe someone else money? It is terrifyingly simple.

We spent more than we earned.

Money is earned by delivering a valuable product or service in which someone has given you something valuable in return. When you operate on cash, you earn the money first then spend it on the things you need and want. When you operate on credit, you spend the money on stuff first (plus the interest) and then try to figure out how to earn it.

It seems backwards to me but the average household is in over $8000 in credit card debt. This is what is considered "normal", yet it is a catastrophe. This logic has seemed to escape the average American household (and the government—that pillar of frugality and thrift).

Good Debt vs. Bad Debt

Let’s look at the two types of debt—the good kind and the bad kind.

The good kind of debt is called leverage or "secured" debt. This is when debt is secured against an asset such as a house, investment property or business. It allows someone to put a small down payment of their own money to control an asset of greater value.

The key here is that one must earn a greater return on the asset than it costs in interest so that profitable leverage actually occurs.

Many people propose that leverage should be used against one’s personal residence. I personally do not. A house is not an income producing asset and actually costs a lot to maintain. It’s a place to live. Paying six figures of interest over a lifetime to live in one doesn’t really make much sense to me—never mind what the government and the accounting profession says. Besides, not having a mortgage frees up your cash flow, and your options.

The other kind of debt is the bad stuff. This is consumer debt such as car loans, personal loans, credit cards, etc. This is the "unsecured" debt that must be repaid from your future income-producing ability. Most of this debt is from purchasing items that depreciate in value plus the added cost of the interest on those expenditures. Now it doesn’t take a PhD in mathematics to realize that it is impossible to get ahead financially by continuing to pay more for things than what they’re worth.

This will kill you.

Say that you have $10,000 on a credit card and you make $10,000 a month in gross income. How much do you have to earn to pay off that balance? Well, it’s a lot more than $10,000 since you have to pay interest, taxes and other expenses. So, let’s be charitable and say it will take 2 months, presuming you don’t spend any money on anything else.

That means that you have already consumed the value of the product or services you have yet to produce. It means that you wanted or needed whatever you charged on your credit cards so badly that you were willing to voluntarily and knowingly place yourself in a position of servitude to the institution that fronted you the money for the next 2 months of your life. There’s a word for that—slavery.

The intelligent use of the good kind of debt can assist you in building your wealth.

The misuse of the bad kind of debt will destroy your financial future more than any other means.

A good financial plan should provide you with the most efficient ways to get yourself debt-free and in control of your financial life.