A broad debate exists in the personal financing community about the value and use of debt. Some believe debt is harmful and irresponsible—and should therefore be avoided at all costs. Others believe that debt is a powerful wealth-building tool—and should therefore be embraced by those who want to improve their financial positions.
So which one is right?
Well, both are. There are times when debt is harmful, of course—and there are other times in which debt can provide exciting wealth-building opportunities.
In this article, I am going to break down the differences between types of debt usage and offer real-life examples of what should be considered “good debt” and what should be considered “bad debt.”
What is debt?
Before we get into how you can use debt to build wealth, it’s important to fully understand the basics of debt.
Debt is really just another term for borrowing money. When you borrow money with a loan—like when you take out a mortgage—you are assuming a debt that must be repaid to the lender. There are countless types of debt, but the basic premise of all debt is that a lender agrees to loan a borrower X dollars at Y interest rate.
The borrowed amount is known as the principal. The interest rate, on the other hand, is essentially the cost of borrowing money. The higher the interest rate, the more expensive it is to borrow the money. The lower the rate, the cheaper it is to borrow.
As a borrower, you want the lowest interest rate possible.
It’s also important to state the obvious here: When you use debt to buy something, you pay more than the list price for that item. If you buy a new TV for $1,000 at a 10% interest rate and pay it off after one year, you ultimately pay a total of $1,100 for the TV rather than $1,000 thanks to the 10% interest that’s tacked on. And, the same is true for both good and bad debt.
What is bad debt?
I am going to categorize any debt that is harmful to your long-term financial position as bad debt. But, to be clear, that isn’t a judgment of those who hold this type of debt. Almost all people, myself included, have used this type of debt, and many people rely on it just to make ends meet. I am calling it “bad” simply because it is bad for your long-term personal financial situation.
The way I define “bad debt” is the money borrowed to finance your lifestyle. This may be a payday loan to buy groceries or cover the costs of an unforeseen expense. Other times, this debt may be taken on to purchase something you want but don’t have the money for—like a vacation, some new electronics, or a new wardrobe.
To be clear, though, taking on bad debt doesn’t necessarily mean you’re buying something frivolous. It means you’re buying something that won’t help you pay off the debt.
As such, this type of debt is harmful in two ways.
The first is that interest rates on this type of debt are often extremely high—at least compared to other types of debt. Credit cards, for example, will typically have an interest rate at or over 20%, and the interest rates on payday loans can average between 15-20%.
Those are extremely high interest rates, especially when you consider that the average interest rate on a 30-year fixed-rate mortgage loan was averaging just 3.1% as of early December. Comparatively, that is not cheap debt. And, if you aren’t careful, the amount you owe on this type of “bad debt” can quickly spiral out of control.
If you need an example of how this happens, take a look at the graph below. This table depicts how at 22% interest, a $1,000 purchase turns into over $7,300 in debt over 10 years.
This is, of course, an extreme example because it assumes you’re not paying off any debt over 10 years. But I wanted to demonstrate the key point here that debt compounds. The longer it takes you to pay off your debt, the faster your debt accumulates.
|Year||Amount Owed||New Debt|
You’re accumulating $220 in new debt in year one, which may not seem very high, but the key here is that the interest compounds. By year nine, you’re accumulating over $1,000 of new debt annually on what you owe. That’s more than the initial purchase!
Given how much the interest can add to what you owe, it’s clear that carrying a balance on high-interest debt is a recipe for disaster.
The second way that this type of debt is harmful is that it makes your lifestyle purchases more expensive. Using debt to make a purchase means that you’re paying more on your purchase than if you paid cash. This can be OK if it’s done from time to time. Over time, however, it can be truly debilitating.
I am generalizing here, but if you are using debt to finance your lifestyle, it likely means that your financial position isn’t very strong. And that’s OK—we all start somewhere.
My point here is that if you’re using debt to finance your day-to-day expenses, chances are that you’re not in a good position to pay off what you owe quickly. When you wait to pay off your high-interest debt, it’s easy to find yourself in a downward spiral—one in which you owe more and more money.
Let’s look at an example using our friend Jessica. Jessica has a W2 job that allows her to save $200 per month while covering her other expenses:
|Groceries & Essentials||$600|
That’s great! Having the ability to save $200 per month is a good place to be at. But now let’s imagine she has an unforeseen expense of $10,000—and she puts it on her credit card at a 26% interest rate.
If she had continued to save the $200 per month rather than using it to pay down the debt, her net worth would sink over a period of 12 years thanks to the compounding interest on the $10,000 purchase.
In fact, just due to the $10,000 purchase with 26% interest, her net worth would be about -$126,000 after 12 years. Yikes!
Now let’s look at a more realistic scenario. Let’s say Jessica used the $200 per month she was saving—which I increase by 3% per year for inflation—to pay off as much of the debt as possible.
Even with that more aggressive repayment plan, she would still have a negative net worth of almost -$99,000. That is debilitating debt.
And remember, this is a scenario in which most months Jessica is living within her means—and is making more than she spends. But the one-time big expense that was financed by a credit card created years of financial distress.
So, it’s pretty clear that high interest debt—debt that doesn’t do anything to improve your long-term financial position—should be avoided as often as possible. And again, I know many people rely on this, but you should try to do it as sparingly as you possibly can.
What is good debt?
Now for the fun part: good debt. It turns out debt can be really bad—or really beneficial!
To me, “good debt” is defined as debt that is used to finance an investment—one that will help you to make more money in the future.
This type of debt can come in several forms:
- Student loans: The amount of student debt in the U.S. is insane, but when used properly, a student loan is an investment. Most college programs have a positive return on investment (ROI)—as I recently discussed on the BiggerPockets Money Podcast—and by taking on this debt, most individuals are making an investment that will help them earn a higher salary in the future.
- Business expenses: If you want to start a business—like a property management company—you need materials. That could be tools, a truck, or anything else related to the company. If you use responsible debt to finance these purchases, this is good debt because they are an investment in your future.
- Real estate loans: This may be obvious to anyone who reads BiggerPockets regularly, but using debt is the most common way to finance real estate acquisitions. And, it is a very powerful wealth-building strategy, too.
To be clear, these loans do cost money. And, by nature, the interest makes the purchases more expensive. But the difference is that these loans are also going toward the financing for money-making ventures. The key is to ensure that the money-making venture has high enough returns to help you pay off the debt and then some.
The other thing to note here is that these types of loans tend to come with lower interest rates. Mortgages are currently between 3-4%, car loans are typically under 5%, and federal student loans rates hover around 3.73% for 2021.
That lower interest rate makes a huge difference. Not only do these loans help you earn money in the future — as opposed to just paying for everyday expenses—but they are also cheaper.
In other words, it’s much less expensive to use debt to finance an investment in yourself than it is to use debt to fund your lifestyle. Remember that.
And, that makes sense, right? Lenders, like banks, set interest rates on loans based, at least in large part, on the risk. The riskier the loan, the higher rate the lender typically charges. That helps to balance the risk-reward profile.
As such, lenders typically see debt that is used to finance an investment as being less risky than debt being used to fund a lifestyle. When a lender funds a mortgage for a rental property, they know that property is likely to generate rent revenue that the borrower can use to pay off the debt.
In turn, the borrower is typically in a better position to service their debt by taking on the loan. That’s a good prospect for the lender—or, in other words, safer debt—so they often lend at lower rates because it’s less risky than it otherwise would be.
On the other hand, when a lender loans money to someone for a lifestyle expense, the borrower is putting themself in a worse financial position than they were before because they’re paying more than list price on a purchase that won’t make them any money. That is riskier for the lender, and the lender charges a higher interest rate to mitigate the risk.
Let’s look at two quick examples of good debt:
First, let’s return to Jessica, who in this scenario takes out a $50,000 student loan at a 4% interest rate. This scenario is similar to the one above. The big difference is that instead of making $3,500 per month from her job, Jessica is now making $4,300 per month because she has a college degree.
While Jessica’s net worth starts deeply negative, in the course of just five years, she has a positive net worth. This is still a lot of debt, but because the debt went toward helping Jessica make more money, the debt was easily serviced and paid off in a reasonable timeframe.
Next, let’s look at an example of using a mortgage to purchase a rental property
In this scenario, Jessica purchases a $400,000 rental property. She put 25% down and the rest was financed with a mortgage loan at a 4% interest rate.*
*Note that this is a super simple deal analysis. This is done intentionally just to show the benefit of debt.
Jessica is taking on a huge amount of debt here of $300,000. That said, because her rental property generates enough rent to pay her mortgage note and break even on expenses, she can easily service the debt.
Over time, Jessica’s property appreciates in value, which I modeled at 2% here. It reaches a value of $487,598 in 10 years due to appreciation. During that same time 10-year timeframe, Jessica is able to pay down $63,648 on the principal and only owes the bank $236,352 when she sells the property after 10 years.
When Jessica sells, her profit is approximately $151,000. This amounts to an annualized ROI of 15% per year. That’s amazing—and isn’t even factoring in cash flow.
Jessica initially invested $100,000 in this scenario, which is just 25% of the purchase price of the property. But because the property grows in value over time, Jessica gets to keep 100% of the increased equity. As long as she pays her mortgage on time, she gets to enjoy the benefits of appreciation and loan pay down—as well as cash flow and tax advantages which are not shown here.
I hope you can see why this type of debt is beneficial! Jessica used debt to purchase a property that made her tons of money over time. Yes, she paid the bank a lot of money in interest over 10-year, but that is the price of her investment, which made her a 15% annualized ROI. That’s a great use of debt!
Another thing to note here is that debt in regard to real estate investing can really scale. As long as you’re using debt to purchase cash flowing properties—and properties that can service the debt—you can get more and more and more debt. It sounds risky, but if your deals are solid, it shouldn’t be.
I am personally millions of dollars in debt from real estate purchases—and I’m thrilled about it. That enormous amount of debt has allowed me to build a cash-flowing portfolio that builds equity over time. And with interest rates as low as they are, I am hoping to go further into debt in the near future.
Are you ready to invest?
One of the most frequently asked questions in the BiggerPockets forums is “How can I start investing in real estate with no money and bad credit?” The answer? You shouldn’t. You need to fix your situation and invest from a position of financial strength.
While these examples are simplified to convey a point, it’s important to recognize that all debt, whether it’s good or bad, comes with risk, and that’s true even if you’re taking on debt to finance a degree, a new business, or a rental property. If you cannot meet the obligations of your debt, you can put yourself into a terrible financial position — and could even face bankruptcy.
To avoid a negative outcome, you should only take on debt that you can confidently pay back. Don’t use a mortgage to buy a home that doesn’t result in cash flow. Make sure you have plenty of excess liquidity in case of an emergency. You shouldn’t be using your last dollars each month to service your debt. You should have plenty of reserves in case of vacancy, big repairs, or some other large expense.
Using myself as an example, all of my properties produce solid cashflow—and I have a W2 job. So, while there is always risk in investing, I feel confident that I will be able to service my debt, even if large unforeseen expenses arise.
The point here is that you shouldn’t be afraid of debt. Debt is a critical wealth-building tool for people who use it responsibly, particularly in the realm of real estate investing—so learn more about it! Do your research, learn what types of debt are best for your needs, and only take on debt that is used to fund an investment into your future.