This post is part of the Carnival of Personal Finance hosted at Simply Forties
Do you know the difference between good debt and bad debt? This isn’t a trick question, but you may be surprised by the answer. Perhaps you have a definition of good and bad debt? It can get complicated! For me, the simplest definition I can use is this:
Good debt is the investment in an asset that makes you money, bad debt is spending money on a liability that costs you more money
Ok, I could probably make that shorter, but I wanted to be descriptive and there are some key words in there that I feel are important. Unfortunately the difference is not always black and white and people with the best intentions of buying an asset, can often end up buying a liability. If you are adverse to debt and only ever want to invest with the money you keep from your pay, then the difference between good and bad debt may not be an issue for you. If you are like me however, and want to leverage your resources then some good debt may be required.
What is a Liability?
Most people know what bad debt is, but tend to ignore it as it is often associated with things that we are attached to. Your credit card, your car, your phone, your clothes and most other things that entertain or make us happy (briefly) are liabilities. I’m not saying we should walk around naked everywhere we want to go and communicate by snail mail, but we do need to manage the bad debt as much as possible. I find a credit card handy, but I pay it off at the end of every month. My family only has one car and we manage. I love my iPhone, but I have a cap plan that I never go over and I only by clothes and other things that catch my eye with the money I have allocated to spend.
What is an Asset?
Wealth creation is about accumulating assets. No matter how you go about paying for them, they need to make you money and provide a return on your investment. When you go to the bank for a loan they ask you for your salary and a list of assets, think very carefully about what the banks definition of an asset is, because it’s not the same as the one above. Banks will consider anything they can sell as an asset – your car, your TV, your house. These things do not make you money.
What’s that you say, but your house is an asset? Perhaps it is, but not always. People tend to buy the home they live in with their heart and not their head and while it is common for housing prices to increase over time, a house can be a pretty big money trap. Your rates, bills, repairs and taxes are not tax deductible for the house you live in. The capital gains may not be as high in the area you have chosen to live in either and all those renovations and DIY projects you do to make it feel more like home may not add much true value to your home. That’s not to say you shouldn’t own your own home, I do and I love it! But your own home shouldn’t be where you put all your money as it might not be the asset you think it is.
Real assets can include high interest saving accounts, real estate, shares, bonds, intellectual property and businesses that will make money without you needing to be present. This is not absolute, any and all of these things may not always be an asset. If you’re not careful, some may turn into a liability! I would also consider education to be an asset, even if it costs you money to undertake the study. If it increases your ability to create wealth, then it is an investment in yourself.
So What about Good Debt?
An asset will always make you money, but there is more than one way to realise this. The money doesn’t always come straight back into your pocket, it might stay in the asset and increase its value. Nothing wrong with that, if you want to use the money to buy more assets you can have it valued and use the money you have made – much better than selling it and losing your asset don’t you think? The money you get based on the value of your asset is a loan, this is where you need to be smart about using it and turning it into good debt.
Do your homework, don’t rush into things and seek out people that can provide the right advice. Debt can be scary and you need to be comfortable with the level of debt you have, this may mean having none at all! My personal philosophy is to invest in what I feel are low risk assets, predominantly real estate as it is what I know and what I am comfortable with. Despite my confidence, there are a lot of people that cast doubt upon this and the most common response I hear is:
If it is so easy, why isn’t everyone doing it?
This comes back to your comfort level with debt. If you understand your level of risk and use all of the resources available to you, then it isn’t too scary at all. The best bit is that those people that are casting doubt aren’t in the game, which means there are more assets available for you and me to collect!
Accumulating assets is the only way that you will increase your financial wealth, good debt will just help you get there a little quicker.