Debt isn’t necessarily good or bad. The difference between good debt and bad debt is how you use it.
I’m a bit of an outsider when it comes to financial bloggers. Read other blogs and you’ll come across dozens of articles on how to pay off all your debt and live debt free forever. You’ll hear how debt, not money, is the root of all evil and why you should avoid it at all costs.
Don’t believe it for a second.
Most of these bad debt bloggers are just repeating the same tired story about how someone got in trouble with debt and it destroyed their financial lives. They use this to assume that all debt is bad and the world would be better off if everyone just paid cash.
They haven’t worked in corporate finance or in the equity markets like I have where you see that debt is a critical part of finance. They don’t understand debt as a financial tool so they avoid it like some money boogey-man.
Understand the difference between good debt and bad debt as well as how to use it and you’ll reach higher financial goals than you imagined possible.
The Difference between Good Debt and Bad Debt
Understanding good debt is as easy as looking at how large companies use debt to lower costs and increase profits.
Apple Inc. has more than $68.9 billion in debt outstanding, that’s almost half of its total financing from loans it has taken out. Since it has a stellar credit rating, it can borrow this money at rates below what investors want for a return on their investment. Interest payments on the debt are also tax-deductible based on online calculators so they reduce the amount owed to Uncle Sam.
The U.S. government owes almost $20 trillion of debt, mostly to its own citizens holding Treasury bonds. The debate around the size of this debt is pretty hotly contested but there’s no doubt that the United States wouldn’t have been able to grow to the world’s largest economy without using debt.
Now I ask you, if Apple can hold $69 billion in debt and the U.S. government can manage almost $20 trillion, do you really think debt is the problem for most Americans?
You see, it’s not that some debt is bad and some good, the difference between good debt and bad is how you use it.
I recently created an infographic comparing some investments and uses of debt against interest rates to see how much better off you would be after 30 years.
- Using a loan to buy real estate amounted to a gain of over $586,000 over three decades
- Investing in your education with a student loan amounted to an 11.6% return and a gain of more than $700,000 over 30 years…besides higher job satisfaction and choices
Shopping for clothes you don’t need is bad debt because you already have something to wear and those new clothes don’t get you anywhere financially. You’ve now got more debt and will soon have just a tattered pile of old clothes.
Good debt are the loans you use to buy assets and other things that at least hold their value. Buying assets like real estate or supplies for your business idea are examples of good debt. You may owe more money but you also own something that produces more money.
How to Manage and Pay off Bad Debt
While you want to seek out good debt and use it responsibly, you definitely need to avoid bad debt and pay it off as quickly as possible. Bad debt can ruin your credit score and lead to a cycle of higher interest rates that will cause you to miss payments.
Credit cards and payday loans are some of the worst debt you can carry.
Dealing with bad credit doesn’t have to be something that takes years or forever locks you out of being able to use good debt. It’s actually a fairly straight-forward process.
- Check your credit report for errors
- Consider consolidating your bad debt into a non-revolving loan
- Ask lenders to increase your available credit
- Rank your debt and make extra payments
It may not seem likely but almost one-in-ten credit reports contain an error. Since just one missed payment or other error can destroy your score, this is the fastest and easiest thing to fix. Check your credit report once a year on annualcreditreport.com for free or sign up for credit monitoring services to see your report and protect against identity theft.
Credit cards are bad debt not just because of the high rates but because they are reported as revolving debt against your credit score. By paying off credit cards with a consolidation loan, you can actually improve your credit score. It’s because personal loans are reported as non-revolving debt and also help to improve your credit utilization ratio.
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That utilization ratio is important because it shows you’re not overextended in debt. It’s the amount of debt you have divided by the total amount of credit on your accounts. By paying off credit cards or asking to get your limit increased, you have more credit available and it looks like you’re in better financial shape.
Finally, learn how to rank your debt by size or interest rate and pay it off faster. Paying off the highest interest rate debt faster will save you money but paying off smaller accounts faster might mean the motivation you need to keep on your budget.
Don’t buy in to the ‘all debt is bad’ slogan you hear on the internet. Debt is a financial tool, used by governments and Fortune 500 companies, and it can help you achieve your financial goals. Understand the difference between good debt and bad debt and how to manage each.
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