All debts are not equal. Debts can be classified broadly into two types. One puts money in your pocket while the other takes money out of your pocket. This means that one type of debt makes you richer while the other type makes you poorer. One is good for you while the other should be avoided as the plaque it is. We are talking about Good Debts and Bad debts.
Let’s start with Bad Debts
BAD DEBTS
This is the type we are most familiar with. You want to make a purchase but you do not have enough cash, so you take out a loan from a bank, friend, or family and pay it back in installments. What makes this debt bad debt is that you use the money to purchase a liability – an item that does not put money in your pocket. The item does not pay for itself. In most instances, the item does not generate cash in any form, rather the item depreciates. This includes consumer items etc.
One of the worst culprits is the automobile. The moment you place a number plate on a car, it becomes a previously owned or second-hand car. It loses about 25% of its value before you drive it out of the dealer’s parking lot. If you do not make a profit from that transaction, that is a bad debt. One way to know if a debt is a bad debt is that the item does not pay for itself; you have to pay for it by yourself. This debt constricts your cash flow and can make life miserable for you. If you borrowed the money from a friend, that can put a strain on the relationship when the debt repayment goes past the due date. This has ended some friendships
GOOD DEBTS
This is the type of debt that comes about from borrowing to acquire assets. The item so acquired pays for itself, you don’t have to pay for it, and rather it puts money in your pocket. This includes borrowing to acquire investment real estate, vehicles for car hire, loans to expand your business, etc. You take out the loan and others pay for it. This means you use debt to build your asset portfolio to become richer rather than borrow to accumulate more liabilities and become poorer (while looking rich on the outside). This is called Other People’s Money (OPM).
You want to get out of bad debt and acquire more good debts. Good debt is an excellent leverage to acquire high-value assets, using the bank’s money. If you want to save up the money, the value may go up by the time you are done saving, making it look like chasing a moving target. With a loan and a good cash inflow, you can accelerate your rate of asset accumulation, growing richer much faster than going it alone.
What type of debt are you most familiar with?
