Welcome to the “2-Minute Money Manager,” a short video feature answering money questions submitted by readers and viewers.
Today’s question is about debt; specifically, whether there’s any such thing as “good” debt, as in debt that doesn’t hurt your ability to achieve financial goals.
Watch the following video, and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript and find out what I said.
You also can learn how to send in a question of your own below.
For more information, check out “7 New Ways to Destroy Your Debt” and “9 Ways to Lose Weight and Pay Off Debt at the Same Time.” You can also go to the search at the top of this page, put in the word “debt” and find plenty of information on just about everything relating to this topic.
Got a question of your own to ask? Scroll down past the transcript.
Don’t want to watch? Here’s what I said in the video
Hello, and welcome to your “2-Minute Money Manager.” I’m your host, Stacy Johnson, and this answer is brought to you by Money Talks News, serving up the best in personal finance news and advice since 1991.
Today’s question comes from Karla:
“What’s the difference between good debt and bad debt? Isn’t all debt bad?”
‘Life or Debt’
In 2001, my first book, “Life or Debt,” was published. The bottom line of the book is that debt is a financial cancer that impairs your ability to achieve goals. It’s something to be first destroyed, then avoided.
Here’s an excerpt from the book:
“When we borrow to buy things, we’re really taking on a third job. Our first job is where we go every morning to collect a paycheck. Our second job is working for our government, since we’re giving a major chunk of our money to them. Our third job is padding the pockets of the giant companies that are in the business of lending us money. Working for your boss and the government is bad enough. But do you really need to go to work for Visa too?”
In short, debt means paying interest. Paying interest makes you poorer. Therefore, you should strive to pay as little interest as possible.
So, debt is bad. Simple, right?
Well, it’s not as simple as it seems. Because there are situations where debt is not only good, it’s fabulous, because it can make you richer.
When bad debt becomes good
Around the same time “Life or Debt ” was published, I bought a waterfront home in Fort Lauderdale. I paid $400,000 for it, which was by far the most I’d ever paid for a house at the time. It was also way more money than I had. So, I coughed up $100,000 of savings and borrowed the rest, $300,000, from a mortgage company.
Fast forward to 2008: Thanks to the real estate bubble that preceded the Great Recession, my home had doubled in value to $800,000.
Now, a math question: What was my paper profit? The house’s value had gone up by $400,000, so it had increased 100%. But since I had only invested $100,000, my profit was 300%. Thanks to borrowed money, I hadn’t just doubled my money; I’d quadrupled it.
This is an example of leverage: using other people’s money to inflate the return on an investment. It’s also an example of good debt, because it made me richer.
Note, however, that leverage is a double-edged sword. Suppose global warming had reduced the value of my house to zero. In that case, I would have lost $400,000 — four times as much as I’d invested. So, while borrowed money can make you rich faster, it can also make you poor faster.
How to tell good debt from bad
Telling good debt from bad is simple enough: If it makes you richer, it’s good. If it makes you poorer, it’s bad.
Using debt to buy clothes, vacations, cars, furniture or anything that goes down in value? Definitely bad. It makes you poorer and the lender richer.
Of course, you may need to borrow. Cars are expensive, and often necessary. But when borrowing to buy depreciating assets, the less you borrow, the better.
Using debt to fund an education, a home, a business or something else highly likely to increase your net worth? Good, at least potentially, since you can make more than the interest you’re paying.
Unfortunately, the line between good and bad is rarely black and white. There’s no guarantee an education will make you richer, or your house will increase in value, or your business idea will take off. So, the rule of thumb is, the less certain you are, the less you borrow.
Hope that answers your question, Karla!
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I founded Money Talks News in 1991. I’m a CPA, and I’ve also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.
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