September 30, 2016

WHAT IS BAD DEBT?

When talking about budgeting, all you hear about is debt, debt, debt. Like most Americans, you begin to wonder what to do because everything in America it seems carries debt. When I talk about debt, I usually think of it in two categories: good debt and bad debt.

Good Debt

This is when I borrow money to make more money.

For example, I borrow money and buy an investment home. I call this home an investment because I rent it out. Each month, my tenant pays my mortgage, taxes, and insurance in the form of rental income. My borrowed money gets paid back without me. Each month, I begin to gather equity in the home and, if I made a good investment, a little extra cash in my bank account.

Good debt could also be that I need to purchase a refrigerator for my house. In today’s market, I go to Sears (if they are still around) buy my refrigerator with no money down and 1-year free financing. I have the cash to pay it off in the bank (note I HAVE the cash).

However, instead of giving it up and saving for two months to pay myself back, I make 1% in interest which helps replenish what I am spending. If I am really smart, I have the cash in dividend paying stocks and my quarterly dividend pays for the refrigerator and I never have to touch the principal.

This is good debt: leveraging my money to work for me. Not once though did I overleverage. I did not borrow what I didn’t have and what I couldn’t pay. Each item paid for itself or was paid for through an investment without costing me my actual cash.

Bad Debt 

This is borrowing money for items that I can’t afford. These items lose value over time and do not provide me with an income in return.

Often, the debt can outlast the value of the item. For example, consider a car. My car is worth less than my loan when I drive it home. This is bad. If I had to sell it tomorrow, I would owe more than I have. While my car provides a service, it is not producing me a return on my money.

If I can pay for my car in cash, but chose not to because I take interest-free financing — this now is good debt. I can pay for the item, but chose to allow my money to grow free of charge.

The key to growing wealth is being able to make decisions, plan for the future, and be in a position that your money is always working for you. Buying a $20,000 car, taking out a full loan, having no cash, and driving it until it is worthless does not help grow my wealth.

Instead, I should have created an opportunity that will pay for my car without myself doing so. Make my money work for me.

In terms of a home, this like all other things, can go both ways. If I buy the most expensive house in the worst neighborhood, do no work, and let it fall down around me, I will lose money. Instead, I should buy a house and acquire skills to make it a better house, thereby increasing it’s value, selling it, taking the profits, and doing it again.

Now my profit is working for me, while I keep a roof over my head. Soon I will have wealth, while others still have debt.

Anna Domzalski is a staff writer for the Financial Bin. Anna will soon begin her role as Dean of Financial Bin University and will conduct online budgeting classes beginning in February 2012. She can be reached via email at Anna@FinancialBin.com.
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