Leveraging Debt: Distinguishing Between Good Debt and Bad Debt
- Bobby & Lisa Campbell
- Nov 1, 2023
- 4 min read
Updated: Apr 20
Introduction
Debt is a double-edged sword that can either work for you or against you, depending on how you use it. In personal finance and investment, the concepts of good debt and bad debt have emerged. Good debt refers to borrowing money to invest in assets or opportunities that can potentially generate a higher return than the cost of borrowing. In contrast, bad debt involves borrowing to finance liabilities that do not appreciate or generate income.
One key strategy in managing good debt is debt leverage, which involves using borrowed money to increase your investment returns. In this article, we will delve into the principles of good and bad debt, the concept of debt leverage, and when it is prudent to use these strategies.
Good Debt vs. Bad Debt
Good Debt: Good debt is a financial tool that can help you build wealth. When you have the means to pay for an item or investment, but the cost of borrowing is lower than the potential returns, it makes sense to utilize some good debt. Some examples of good debt include:
a. Real Estate: Taking out a mortgage to buy a rental property, where rental income covers the mortgage payments and yields a profit. (Disclaimer, having 6+ months emergency funds for sustaining that property and proper evaluation of the value of the asset is critical)
b. Business Loans: Borrowing capital to start or expand a business that generates significant profits beyond the interest costs.
c. Investment Loans: Using margin loans to invest in stocks or other assets with strong growth potential, provided you can manage the associated risks. Remember prudence is the better part of valor.
2. Bad Debt: Bad debt, on the other hand, refers to borrowing money to finance expenses that do not contribute to your financial well-being or generate returns. This includes credit card debt, high-interest personal loans for non-essential purchases, and loans for depreciating assets like cars or luxury items. These forms of debt can quickly erode your financial stability, as they often come with high interest rates and no potential for appreciating value.
Debt Leverage
Debt leverage is a strategy employed by individuals and businesses to magnify their potential returns on investments. This tactic involves using borrowed funds to amplify the size of an investment. When done right, debt leverage can significantly boost returns, but it also entails risk.
Rental Properties: One common example of debt leverage is investing in rental properties. You purchase a property with a mortgage, and the rental income covers the mortgage payment, property maintenance, and provides a profit. The key is to ensure that the rental income surpasses the cost of borrowing and other expenses, allowing you to build wealth over time while minimizing your own financial commitment.
Stock Market: Debt leverage is also used in the stock market through margin accounts. Investors can borrow money to buy more stocks than they could with their own capital alone. This can amplify gains when the market rises, but it also magnifies losses when it falls, making it a strategy best suited for experienced investors who can manage the additional risk.
When to Use Good Debt and Debt Leverage
When Investment Returns Exceed Borrowing Costs: The primary principle of good debt is to ensure that the returns on your investment exceed the cost of borrowing. It's critical to assess potential investments carefully, comparing the expected returns to the interest rates and other costs associated with the debt. This applies to rental properties, businesses, or any investment opportunity.
When You Have a Financial Cushion: Using good debt requires a safety net. Ensure you have an emergency fund and the ability to make debt payments even if your investment does not perform as expected. Never put yourself in a precarious financial situation. I keep personal liquidity separate from any sort of investment liquidity. Meaning I create a financial cushion not only for my living expenses, but also for each asset or investment I make. Each one has its own cushion built in. This allows decisions to be made, not from a survival mindset, but from a long term growth mindset.
When the Investment is Sound: Thoroughly research and evaluate any investment opportunity to minimize risks. A strong business plan, due diligence, and a well-thought-out strategy are essential for success.
When you are stable: You have secure income established for all your normal day to day life needs.
When Not to Use Good Debt
For Non-Essential Expenses: Avoid taking on debt for non-essential purchases like vacations, luxury goods, or other depreciating assets. These can lead to a cycle of bad debt and financial stress.
When You Can't Cover Borrowing Costs: If you cannot comfortably make debt payments from your income, it is unwise to use good debt. Overleveraging can lead to financial disaster.
Conclusion
Good debt, when used strategically, can be a powerful tool for building wealth and achieving financial goals. Debt leverage, in particular, can help you amplify your investments and generate higher returns, provided it is used wisely and responsibly. It is crucial to distinguish between good and bad debt, assess your financial situation, and carefully evaluate investment opportunities before deciding to leverage debt. When employed judiciously, good debt can help you grow your wealth over time and make your money work for you.
- Bobby Campbell
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