Is debt good or bad?

As you save money, opportunities to utilize both “good debt” and “bad debt” will arise. Good debt gains you exposure to attractive assets and allows you to participate in their growth at an affordable cost. Bad debt, such as credit card debt, can be extremely costly as you’re often paying high compound interest rates on depreciating goods. We always want to ensure that compound interest is working for us and not against us.

Video transcript

It’s a common misconception that all debt is bad. This just isn’t true. There are two types of debt — good and bad debt. But before we start, let’s first take a look at how debt works.

How does debt work?

When you take on debt you are borrowing money that you will have to pay back later. This money will have to be paid back with interest, which is your cost of borrowing. For example, say you borrow $1,000 from the bank. You and the bank agree that you will pay it back in one year with 5% interest. In one year from now, you pay back the $1,000 and you also pay $50 in interest. You spent $50 to borrow $1,000. Seems simple enough.

Now, there are a variety of things that you can take on a debt to buy. Some of these things are a good idea. Others are not so good.

What is good debt?

Good debt is a good idea. Good debt generates revenue or increases your net worth. Anything that appreciates or increases in value for you over time or generates an income for you is good debt.

The most common example of this is buying a house. Say you buy a house for $600,000. You borrow this money from the bank in the form of a mortgage that you will pay monthly over 10 years. In 10 years, the house is now worth $1 million. Although you had to pay the bank interest to borrow money, the house is now worth $400,000 more and your net worth has increased. Other examples of good debt are buying a business or investing in yourself by taking out student loans.

What is bad debt?

Bad debt is the opposite. Bad debt is borrowing money for anything that depreciates in value over time.

For example, you buy a new iPhone on a credit card. As soon as you start to use it, it’s immediately worth less. If you try to sell this iPhone on Craigslist, the next buyer will not buy it at the price that you bought it at. The value has depreciated.

Other examples of this include cars, vacations and clothes. Although it’s fun to have these items now, over time, they will be worth less, and you will still have to pay back the money plus interest. In short, if you can’t afford these things, don’t use debt to buy them.

To sum up, take on good debt to seize opportunities that will make you more money over time. Don’t take on bad debt to buy items that will be fun now but worth less later.