Comparing Good Debt and Bad Debt

Not all debt is an inherently problematic issue; there is good debt and bad debt. Nearly every American household and business operates on a debt cycle. In many ways, debt helps to advance personal and corporate wealth. However, when debt gets out of control, it can become a plaguing financial issue. Personally, you should aim to carry debt at low interest, worth a low percentage of assets and aimed at building wealth.

Low Interest Loans

The difference between a low interest and a high interest loan is striking. With a low interest loan, you may actually make money by going into debt instead of purchasing an item up front. Consider these two scenarios:

You have $20,000 to purchase a car. Instead of buying a car up front, you spend only $10,000 on a down payment and finance the other $10,000. You get a low, 4% APY on a 3 year car loan. The financing costs you around $500 total. During the three years you have the loan, you invest the $10,000 you did not place down on the car. You invest conservatively in a CD, and you earn $800 on the investments. You will save about $300 by choosing to finance a portion of the car.

This is a very simple example with a low total amount of loan dollars. On a mortgage loan, the amount you make on interest from investing money can largely outweigh the cost of financing your home. As long as your interest is low enough, it makes more sense to keep the money growing in your pocket rather than handing it over immediately.

Low Debt to Asset Ratios

Even low interest debt can be a bad thing if you are carrying too much of it. You should always have more assets than you do debts. This will protect you from bankruptcy and lead to financial freedom. Depending on the type of debt you are incurring, the percentage of your total asset base will be large or small. For credit card debt, you should aim to maintain a balance lower than 10% of your credit line limit. Any more, and you will be losing money in financing costs unnecessarily.

For something like a mortgage, though, it may be possible to carry 50% or 60% of your total wealth in a single debt. Utlimately, with a mortgage, the comparative cost of renting over time will still be higher than financing this huge sum. This is only true if the interest is low enough, the rate is fixed, and you can afford the monthly payments. In the end, though, it is acceptable to carry a high mortgage load.

Loans to Build Assets

The real question at the end of the day is: what do you have to show when your loan is paid off? Have you built an asset and gained financial independence? Are you wealthier at the end of the loan than at the beginning? Or, have you simply purchased beyond your means. Loans aimed at building your overall wealth, such as business and home loans, will always pay off more than credit spent on clothing, vacations and other disposable items.

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