Good Debt vs. Bad Debt: Is There A Difference?
Reading that probably made you feel something. Like an F-bomb, the word debt provokes a reaction.
You might have felt panic. You wouldn’t be alone. Most people have an irrational fear of debt.
We’re taught that debt is a terrible thing from an early age. People in a lot of debt are pitied and looked upon as failures.
Others are more blasé in their approach to borrowing – usually the young, inexperienced handler of money.
They have no issue with purchasing a car on finance, and they regularly go into debt for stuff they don’t need. And why wouldn’t they? It’s no biggie; you can pay it back.
So, who’s right?
Should you avoid debt at all costs, or is it a necessary part of modern life?
To make that call, I think we first need to understand that not all debt is equal.
The Difference Between Good and Bad Debt
There is a BIG difference between types of debt, which most people differentiate as being good or bad.
If you’re profusely shaking your head and mumbling “No, no, all debt is evil!”, think about this:
Many of the great companies we love wouldn’t exist if it weren’t for the seed money they used to launch their idea to the world.
On a smaller scale, the local cafes and restaurants you frequent likely used debt to get their business off the ground or to see it through a hard time.
And doctors, lawyers and other professions we rely on for our societies to function often take on massive debt to fund their education.
So, some kinds of debt are extremely beneficial, both for the borrower and for our communities.
But, of course, there is bad debt.
These loans often only benefit the lender – although the borrower thinks they’re getting something of value at the time.
The fundamental difference is that good debt is used to purchase assets or to create or increase income, whereas bad debt is used to buy liabilities and for lifestyle inflation.
Using good debt wisely can produce fantastic outcomes.
Bad debt, almost always, has disastrous consequences.
Or, simply put:
Good debt is really good. Bad debt is really bad.
The Benefits of Good Debt
Used wisely, debt can be utilised to build great wealth.
If you borrow to invest in assets, you’ll make more money than if you didn’t borrow.
Leveraging your investments amplifies your returns as you use less of your own money, but you’re still benefiting from the same growth.
As long as the return on investment is greater than the cost of borrowing, then leverage is a brilliant and powerful tool (disclaimer – borrow to invest with caution and only if you’re knowledgeable about the asset and fully aware of the risks).
Examples of Good Debt
- BTL Mortgages – you’re using the bank’s money to purchase an asset that pays you every month and appreciates in value.
- Student Loans – money used to fund an education that increases your earning capacity is good debt. BUT… not all degrees are worth going into debt for. I’m looking at you, English Literature.
- Business Loans – If you can get to profit using only your own capital, fantastic. But if your venture requires taking on a little debt to get off the ground, it could be a risk worth taking.
The Downside of Bad Debt
Bad debt can be fun at first. Most people that get themselves into credit card debt usually do so through lifestyle inflation, and not because they’re teetering on the edge of survival.
But the good times will end, and the hangover will come.
And just like when you mix your drinks and take it way too far, that hangover will be regret-filled-head-thumping horrible.
Bad debt casts a permanent shadow over your life.
It plagues your thoughts with worry and keeps you up at night.
If you can, AVOID AVOID AVOID it at all costs.
Examples of Bad Debt
- Credit Card Debt – the obvious one. Credit card rates are ridiculously high. You face an uphill battle trying to repay loans that are growing at 20%+ per year.
- Personal Loans – unless you’re using it to invest (which you shouldn’t be), personal loans are burdening you with consumer debt.
- Overdraft – overdraft rates can be as high as 49%! Avoid using your overdraft even if you’re only using it for a few days to bridge the gap until payday.
- Car Loans – Borrowing to buy something that halves in value as soon as you drive it off the lot and that also depreciates every year is not a smart move.
- Home Mortgages – this is a controversial one. If you were to look at it from a purely financial standpoint, your home is a liability. You have a mortgage to pay (most of which is interest) and the cost of upkeep. But many people (myself included) view homeownership as a worthy use of their money.
If you’re still of the opinion that all debt is bad, that’s cool – each to their own. But we can at least agree that some uses of debt are smarter than others.
My own opinion and use of debt has flipped 180.
I’ve been in debt my whole adult life.
The first five years were all bad debt, but now it’s mostly good.
My Early Days Of Bad Debt
My childhood experiences of money were painful.
I remember watching my mum cry unconsolably over credit card debt and the phone calls from debt collectors.
My parents had racked up thousands of pounds in credit card debt living a life they couldn’t afford.
There were fights, tears and a lot of stress and anxiety.
As a young adult, I was terrified of debt. As far as I was concerned, debt was Samuel L Jackson in Pulp Fiction; a Bad Muthafucka, not to be messed with.
When I left home, I was (fairly) responsible and got a job to help pay my way while studying.
But I never learned how to manage money, and it wasn’t long before I ended up in debt.
It started off with occasionally dipping into my overdraft. Then I would use student loans to fund my party lifestyle. And once I received my first credit card, the flood gates opened.
I borrowed to buy things that I wanted but didn’t need.
The things I bought I no longer have (or can remember), but I’ve paid for them many times over in interest.
How I Utilise Debt Today
Today, I am in more debt than ever before.
I currently owe £487,289.54
“WTF!?!? HALF A MILLION POUNDS IN DEBT! And you’re someone that blogs about how to be good with money?”
Yep, nearly half a million in debt… and I would take the other half if the banks would give it to me.
But, the vast majority of that is good debt.
Besides my home mortgage, all the money I’ve borrowed has been used to purchase rental property.
Using a buy-to-let mortgage gives me a much better ROI, increases my diversification (by allowing me to own several properties), and will lead to greater wealth in the long run.
I’m probably best showing the benefits of leveraging a buy-to-let property through an example:
Buying BTL Property With And Without A Mortgage
I initially bought this house with cash.
Buying BTL Property With Cash
Mortgage Broker Fee
Total Purchase Costs
Net Monthly Rent
Return On Investment
Six months later, I got a mortgage on the property, which had now increased in value to £75,000 due to refurbishing it. I released £56,250 for further investment, and my total money left in the deal was £11,555.
The mortgage cost is £97 / month, which reduced my cashflow to £360 / month. But as I only have £11,555 of my money still invested in the property, my ROI is a whopping 37.4%.
Buying BTL Property With Mortgage
Cashback from 75% LTV Mortgage
Mortgage Arrangement Fee
Total Money Left In Deal
Net Monthly Rent
Return On Investment
As you can see, debt can be used to greatly boost your investing returns.
BUT, I’m not advocating everyone takes out a loan to purchase assets. There are risks involved.
Buying rental property (or any investment) with cash will always be the safest way of investing.
I’m comfortable using debt to build my property portfolio as property is a relatively stable asset, I have nearly a decade of experience in property, and I have systems in place to combat the risks.
But this approach is not right for everyone. And again, I’m not suggesting you borrow to invest.
The Final Word
As someone that’s experienced both good and bad debt, I think there is a clear difference between the two.
Good debt puts money in your pocket, bad debt takes it out.
Good debt can make you extremely wealthy, bad debt will keep you broke.
Good debt can fund your education, advance your career, or help you start a business. Bad debt buys you a bigger TV, a nicer car, and fancier clothes.
But the biggest difference between the two is the mindset you have when in debt.
When I was in bad debt, I was all about immediate gratification. I wanted to live large without putting in the time to earn it.
Now I’m in good debt, I view debt as a tool to increase my wealth and income.
The thought of using such a powerful tool to buy junk now seems as crazy as cutting my hair with a chainsaw.
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Hi! I'm Jamie
I’m a 30-something money blogger that writes about saving, frugal living, investing and entrepreneurship.
I achieved financial independence at 30 through hard work, saving and learning to invest.
On this blog, I share everything I've learned about money to help you build a life you love, free from money worries.
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When I first got interested in personal finance, I stumbled across a blog called Early Retirement Extreme (ERE). The blogger behind the site, Jacob Lund
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