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Good Debt, Bad Debt: Know the difference

Does debt make you richer or poorer? Ask a poor or middle class man, and he will say it makes me poorer.  Ask the rich, and he will say that it makes me richer. Why are the answers at the opposite ends of the spectrum? The reason why the answers differ is because of the kind of debt that each class refers to. The poor and the middle class look at all debts are ‘bad’ debts, whereas the rich look at debts as ‘good’ debts. Now, what’s the difference between ‘Bad’ and ‘Good’ debts? The former takes money out of your pocket, whereas the latter puts money in your pocket. Understanding this fundamental difference will do you a whale of good when it comes to financial management. Let’s explore further.

Before we try to understand Good vs. Bad debt, we need to put down a simple definition of an ‘Asset’ and a ‘Liability’. Asset – Anything that puts money in your pocket.  E.g. House being rented out to tenants.  Liability – Anything that takes money out of your pocket. E.g. House that is being used for personal use. So you can see, the very same property can be classified as an ASSET or a LIABILITY, depending on how it is being put to use. Now that you have understood the definition, let’s look at good vs. bad debt.

A BAD debt is money borrowed to buy a LIABILITY, whereas GOOD debt is money borrowed to buy an ASSET. Now this is where things have to be made a bit clearer. Let’s take an example:

CASE I: You take a bank loan of $100,000 to buy a 1-bedroom condo to move into and your monthly installment to the bank is $1000. In this case is your debt a good or a bad debt? If you answered BAD, then you have got the point. But if you answered GOOD, then please go back and read the difference a good and a bad debt. To repeat myself, the condo that you borrowed money for is NOT putting money in your pocket; instead it is taking money out of your pocket in the form of monthly installments of $1000.

CASE II: Now let’s imagine that you put this 1 bed condo out for rent, and you get a monthly rental of $800. In this case, what do you think the condo is? An Asset or a Liability? If you answered Asset, then you need to go back and read the definition of an asset. As you may notice, every month $200 ($1000 bank installment – $800 rental income) is going out of your pocket. So this condo still is a LIABILITY.

CASE III: Let’s assume that you renegotiated the rent with the tenant and now he has agreed to pay you $1200 every month. I believe you would have figured out by now that your condo has turned into as asset because it puts $200 in your pocket.

So the next time round you go looking around for a new plasma TV with a credit card in hand, think twice. You are using borrowed money or debt to buy a liability. Now that is BAD debt. Now that you a bit wiser, I would expect you to make an informed decision.

God bless.

About the Author

John Bino is an entrepreneur and success coach specializing in helping fellow entrepreneurs and the community at large to realize their true potential. His mission is to help people become more valuable to their family and the marketplace.

For more information on John Bino or to contact him, go to either his blog http://www.parentsINCorporated.com or to his business website http://www.earnwhatyoudeserve.com

 

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