Good Debt vs. Bad Debt

Key Takeaways

• The Mindset Shift: Debt is not inherently evil; it is a neutral tool. It amplifies the outcome of your decision.
• Bad Debt: Borrows from your future to pay for consumption today (depreciating assets).
• Good Debt: Uses other people's money to buy cash-flowing assets (appreciating assets).
• Leverage: The mathematical power to multiply returns, but also multiply risks.

Introduction

We are taught from a young age that "debt is bad." Avoid it like the plague. If you don't have the cash, don't buy it.

This is excellent advice for impulse purchases (shoes, TVs, vacations). If you follow it, you will never be poor. However, you might also never become truly wealthy.

The wealthy do not avoid debt. They use debt. They use it as a tool, a lever to move heavy financial objects that they couldn't lift with cash alone. To master money, you must graduate from "Debt is evil" to "Debt is a loaded gun"—useful if you know how to handle it, dangerous if you don't.

Deep Dive: The Tale of Two Debts

The Difference: Consumer vs. Producer Debt

To understand debt, you must classify it by what it does, not what it is.

1. Bad Debt (Consumer Debt)

Bad debt is money borrowed to purchase an asset that depreciates (loses value) or holds no value at all. You are paying interest to become poorer.

• Examples: Credit card debt for clothes, payday loans, financing a luxury car, vacation loans.
• The Math: You pay interest (often 20%+) on an item that is becoming worth less every day. It is a double-negative for your net worth.
• Rule: Avoid at all costs. Pay this off immediately. It is a financial emergency.

2. Good Debt (Producer/Leverage Debt)

Good debt is money borrowed to purchase an asset that appreciates (gains value) or generates cash flow greater than the cost of the debt.

• Examples: A mortgage on a rental property, a business loan for equipment, student loans (if and only if the degree creates high ROI).
• The Math: You borrow at 6%. You invest in an asset that pays you 10%. You keep the 4% spread. You are making money using other people's money (OPM).

The Power of Leverage

Let's look at a concrete example of why real estate investors love debt. Let's say you have $100,000 to invest.

Scenario A: No Debt (All Cash) You buy a house for $100,000 cash. The house appreciates 5% ($5,000) in one year.

• Return on Investment (ROI): 5%.

Scenario B: With Good Debt (Leverage) You use that same $100,000 as a 20% down payment on five $100,000 houses (Total asset value: $500,000). You borrow the rest ($400,000) from the bank. The houses still appreciate 5%. That is $5,000 x 5 houses = $25,000 total gain.

• Return on Investment (ROI): 25% ($25k gain on your $100k cash).

Leverage quintupled your wealth growth.

The Risks of Leverage

Leverage is a double-edged sword. It magnifies gains, but it also magnifies losses.

If housing prices drop by 20% in Scenario B, your entire $100,000 equity is wiped out. You are bankrupt. In Scenario A, you still have an asset worth $80,000.

Rules for Using Debt Safely:

1. Positive Cash Flow: Never take on debt for an investment that doesn't pay for itself today. Do not bank on future appreciation. The asset must cover the loan payment every month.
2. Fixed Interest Rates: Variable rates are dangerous. If rates spike, your payment skyrockets, and your cash flow turns negative. Lock in fixed rates.
3. Reserves: Never leverage without a cash cushion. If the tenant moves out, can you pay the mortgage for 6 months?

Summary

Don't be afraid of debt, but respect it. Use debt to buy assets that pay you. Use cash to buy liabilities that cost you.