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Good Debt vs. Bad Debt

By Bigg Success Staff
02-07-08

Timeless Principles

Albion knight sword 

Many of the wealthiest people in the world built their fortunes using debt. Most people who file for bankruptcy got to that point using debt.

Debt is a double-edged sword. So how do you make sure it doesn’t stab you?

When we borrow money, we trade part of our future for the present. We enjoy the benefits of spending money now, with the understanding that we have to pay it back in the future. So how can that ever be good?

What is “good” debt?
Good debt makes us money. We borrow money to buy an asset now that pays for itself. We purchase something that comes with income. We use that income to pay back the loan. It’s just a matter of time before we have a debt-free asset. We have created wealth.

What is “bad” debt?
Bad debt costs us money. When we spend borrowed money for anything that won’t pay for itself, we’re borrowing from our future to pay for our present. We will have less wealth in the future because we made this purchase.
 
An example of each
Sissy wants a new plasma TV. She doesn’t have the cash to buy it now. She doesn’t even need to buy it now; the TV she’s using works just fine. But her neighbor just got a new TV and she wants to one-up him! She’ll just use her credit card – after all, the minimum payment isn’t that bad.

Sassy wants a new plasma TV as well. She even has the cash to buy it, but her TV works just fine. Besides, she’s busy tending to her investments; she doesn’t watch that much TV anyway. And she wants financial freedom more than the TV. So she uses her money to buy a small rental property with three partners. The rents will cover all her costs. Before you know it, she’ll have it paid off.

Do you see the difference? Sissy is taking on debt to buy something that will only go down in value. It won’t make her money … it will cost her. Sassy is building her net worth and creating a better future for herself.

It would be one thing for Sassy to buy the TV – she has the money! Sissy is just subjecting herself to have to continue slaving away for every dollar.

Can good debt turn bad?
There are some inherent assumptions in Sassy’s situation. You need to carefully consider your specific opportunity before you sign on the dotted line.

Ask yourself, “What if?” In order for it to truly be good debt, you have to be able to withstand some unexpected events. For instance, what if you can’t keep the property fully occupied? What if you have extended periods of time without a renter? What if you have a major repair? And on and on.

What’s your contingency plan?
Now that you’ve considered what could go wrong, determine what you would do if that happened. You may establish a cash reserve upfront to cover lengthy vacancies, major repairs, and the like. You may set money aside each month as the rent comes in for these types of things.

Whatever you do, expect the unexpected by planning for it in advance. That way, when something happens, you’ll know how to respond quickly.

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