You might have heard these terms thrown around.
But how do you know if debt is good or bad?
The distinction is actually very simple.
If you go into debt for something that:
- Goes up in value
- Makes you money
Then this debt has potential to be good debt.
If you go into debt for anything else, it's bad debt.
Let's go through them:
This is probably the most common thing people go into "large" amounts of debt for, often millions of dollars.
Generally houses go up in value, so a mortgage isn't considered bad debt.
However, there are caveats.
Your home generally doesn't produce any income.
On the contrary - it actually produces a lot of expenses.
You have rates, insurance, repairs and maintenance, body corp, not to mention furnishings, utilities, legal fees etc etc.
The only way you will ever realise income from your house if when you sell it.
This means your home will most likely have negative cashflow. Your home causes a lot of money to leave your bank account, but doesn't bring any money in.
While your home mortgage isn't bad debt, it isn't great debt either. Try and keep your home mortgage as low as possible. Even if you get approved for a $1 million mortgage, you don't need to spend all of it. Buying a small house to live in is a good financial decision.
A mortgage on an investment property is much better debt than a mortgage on a home.
The reason is simple - an investment property produces income, and your home doesn't.
However, the debt on an investment property is not as good as it used to be after the tax changes we saw in 2021 - interest on investment properties acquired after March 2021 are no longer tax deductible in New Zealand.
This doesn't change the fact that debt on investment properties are superior to debt on your home, because the interest on your home mortgage isn't tax deductible either.
Property has historically been a very good investment, and generally goes up in value over time.
This means going into debt to buy an investment property is generally good debt, as long as the numbers make sense.
Stocks go up in value and also produce dividend income, so going into debt to buy stocks can be considered good debt.
It's marked with an asterisk though, because even though it's good debt, most people should stay away from it.
The reason is because stocks are volatile, and even though stocks have reliably risen in value over the last 100 years, most people do not have the temperament to weather volatility.
The second reason is, it's very difficult to get loans to buy stocks with a decent interest rate.
Because most lenders consider stocks to be risky, interest rates are generally high.
However, if you are able to buy stocks in a sensible way (broad index funds) while borrowing funds at very low interest rates, then this can be an excellent source of debt. An example of this is described in this article.
Student loans in New Zealand are a very good source of debt.
There is no interest on your student loan, meaning if you want to go to university, there is literally zero downside to taking on this debt.
There is also no obligation to start repaying your loan until you start earning.
The added bonus is, going to university (hopefully) is an asset that will help you make/increase your income.
You get all the benefits of debt, and none of the downside.
I recommend everyone who wishes to do tertiary study to get a student loan, and don't pay off any more than the minimum requirements.
A business and/or assets for your business
Taking out a loan to buy a business can be good debt, with the obvious caveat that the business is making money and/or you have the required knowledge to run the business.
Buying assets that help you run a business are also good sources of debt.
For example, let's say you want to drive Uber, but you don't have a car.
You borrow $5,000 to buy a car, and then start driving Uber and making $500 per week.
This is good debt - because you've used it to buy an asset that is making you money, and you are earning enough to cover the loan repayments and make a profit.
The concept is the same whether you're buying a car for Uber, or buying a delivery business with a fleet of 30 cars.
As long as the debt is to purchase something that produces income, the debt is good.
Bad debts are bad for all the same reasons.
Whether you're using the debt to pay for cars, clothes, phones, vacations, weddings, or whatever else that you are simply consuming, the debt is bad.
The reason is simple - this debt makes everything more expensive, and doesn't produce income.
Let's say you buy a phone for $2,000 on your credit card.
The average interest rate on a credit card is 19%.
This means you'll be paying an additional $380 per year in interest for your phone, or $32 per month.
Not only do you not need a $2,000 phone (nobody does), you can't even afford it, and the irony is because you can't afford it, you actually end up paying way more than the actual price tag because of all the interest you will rack up.
This is a prime example of bad debt that will keep you broke.
Another common example of bad debt is buying a car.
Many people who buy expensive cars can't afford them outright, therefore they need to get financing and go on a payment plan.
Let's say you want to buy a $15,000 car. You have no money (because you just bought a $2,000 phone) so the dealership offers you financing - you can pay the car off over 4 years, at 9% interest, which works out to just $345 per week.
You think - Great! I can afford that! And you sign the contract.
Let's look at what you actually agreed to:
Even though the car is only $15,000, you'll end up paying an extra $1,580 in interest.
Meaning the car actually costs you $16,580.
Add in all the other car expenses like insurance, WOF, registration, servicing, gas, parking, repairs, cleaning, the car is actually likely to cost you over $20,000.
That's not all - after four years when you've finally paid of the car, it won't even be worth $15,000 anymore.
Its value would have fallen to probably $8,000.
You just paid $15,000, and $1580 in interest, and $5,000+ in expenses, for a car that's now worth less than half that.
And here's the real kicker - how much income did the car produce?
Another example of bad debt that keeps people broke.
What would be a better financial decision?
Catch the bus. Ride a bike. Or buy a cheaper car.
Ideally, do all three.
Here's how: Catch the bus and save your $345 monthly car payment. After 6 months you would have saved over $2,000. Use that to buy a cheaper car in cash.
Now you have a car, it's a smaller and cheaper, which means it's cheaper to insure, and uses less petrol, it's fully paid off (because you bought a car you can actually afford) so you have no car payment, you're paying no interest, and most importantly you have an additional $345 you can invest into stocks each month.
After 4 years, instead of having lost half your money on a $15,000 car, you would have a $2,000 car and almost $19,000 in stocks.
Now you're not in bad debt, and you're not behaving broke.
Instead, you're on the way to becoming rich.
In fact, in 30 years, that $19,000 in stocks would have grown to almost $300,000:
Over a quarter million bucks.
Just from not buying that stupid car you can't afford.
When I say becoming a millionaire is simple, I really mean it.
Catch the bus for six months and you're a quarter of the way there.
If it's going to make you money or go up in value - good debt.
If it's not going to make you any money or go down in value - bad debt.
Following these two rules, compounded over decades, can literally be the difference between retiring at 40 and retiring at 65.