Scientists have shown that when we pay money, it registers in the same part of our brain as pain. 
Photo by Towfiqu barbhuiya on Unsplash
It should come as no surprise, then, that we want to pay as little as possible. Some have taken this to extremes, however, and want to reduce payments, even at the expense of their financial well being.
You may have heard of some of these “gurus.” They tout their “zero debt” plans as the path to financial well being.
But the truth is that they’re only showing people part of the story.
Debt can be used to make your Net Worth grow faster. It can give you access to tools and opportunities that you wouldn’t otherwise be able to use.
The greatest skill comes from learning to tell Good Debt from Bad Debt.
What is Bad Debt?
Bad Debt is probably most of what you’d think of when “debt” comes to mind.
It’s consumer credit cards with high interest rates.
It’s doing a cash out refinance to go on a vacation.
It’s funding your present by borrowing from your future.
If the major gurus wanted to really help educate people, they’d focus on helping people identify these types of debts.
In fact, you can put the strategies and tactics they teach to good use when directed solely at Bad Debts. Bad Debts must be eliminated as quickly as possible, as they can create the largest drag on your financial well-being.
What is Good Debt?
In short, a Good Debt is a debt that will lead to larger earnings or value than you will pay, even with interest.
We have more specific rules for clients to guide them in their decisions, but for now let’s look at it in terms of a couple scenarios:
Scenario #1
Maria buys a new laptop for work with a plan that has 0% interest for the next 12 months. After that, she’ll have to pay 29% interest on the remaining balance. Bella looks at her monthly budget and reasons that she can pay the loan back within a year.
Is this good debt or bad debt?
This is a good debt! Because she sees that she can repay the financing within a year, she’ll effectively be paying 0% interest. That means she’ll get the value of the laptop, along with the increased earning power from her job, and she won’t have to pay any extra. She’s definitely getting more value than she’s paying.
Scenario #2
Connor’s car works well, but he likes the features of the newer models, so he trades in his current car for a brand new one. The financing ends up running him about $20,000 over 60 months, with an interest rate of 18%.
Is this a good debt or bad debt?
This is probably a bad debt. Connor already owned a car, so a new car won’t lead to greater earnings. Plus, he will be hard pressed to get increasingly greater value that will exceed such a high interest rate. Since he’s purchased a new car, the car will actually depreciate in value pretty quickly.
Scenario #3
Alfred and Milly have wanted to go on a vacation for the longest time. They see a commercial advising them that they can pull money out of their house by doing a cash out refinance. So, they do a refinance which ends up giving them the money they need for a vacation. They get an interest rate of 2.95%, and their closing costs are about $1200 in total. They go on their trip two months later and have a fantastic time.
Is this a good debt or bad debt?
Mortgages are incredibly useful for increasing Net Worth, and many people are unnecessarily frightened of them.
However, this is not the proper way to use a cash out refinance, and falls under a Bad Debt?
Why?
A vacation is a wonderful thing, but even at a low interest rate, Alfred and Milly will be repaying it for years to come, and will therefore be paying much more for the vacation than they realize.
Scenario #4
Sandra takes out a federal student loan to go to college. She completes her major within a few years and locks in a 5% interest rate.
Is this a good debt or bad debt?
This can be a good debt! A degree should give her the ability to earn more money. Some studies find that a degree leads on average to an increase in salary of about $32,000 more per year. That increase in salary will be able to more than pay for the interest she’ll be paying.
Are you starting to get the picture? Sometimes debt can actually be good and lead to better things! The real skill lies in identifying those opportunities, rather than letting others scare you away.
If you want to learn how to identify these opportunities, click here to sign up for a FREE Bronze account. You’ll get an email from a licensed financial advisor to set up a complimentary strategy session so they can help you identify the good debts in your life that you can take advantage of, and the bad debts that you’ll need to wipe out right away.