Good Debt vs. Bad Debt

Just what is Good Debt?

Good Debt is debt that allows you to create a positive cash flow.
Bad Debt is... everything else.
Credit cards are the worst form of bad debt. Now I am speaking of the spending habits of the general American public that has been brought up in and trained in the Industrial Age way of thinking. From the teenage years we have been taught that we need credit. "Get a car loan to build your credit," or " Get a credit card so that you can start building your credit," and this is a good one "Buy a house so that you can have a tax deduction." Yes, we need good credit. These are ways to obtain a credit history and thus a credit rating but these are only half truths. If we don't teach that teenager that a credit card is for needed purchases when cash is not available or for emergencies, then we are teaching instant gratification with out realizing just how fast the balance can and does grow.

We are living at a time that I think someone that can fog up a mirror can get a new car loan. Again, instant gratification on a monthly installment plan.

Interest. Simple or Compound. I would bet that I would be hard pressed to find many college students that could tell me the difference.

Interest is a fee, paid on borrowed capital.

Simple Interest is calculated only on the principal, or on that portion of the principal which remains unpaid.
Compound interest is very similar to simple interest, however, as time goes on the difference becomes considerably larger. The conceptual difference is that unpaid interest is added to the balance due.

A new car is a depreciating asset. What this means is that at the moment the car is purchased it becomes a "used vehicle" and thus is not as valuable as a "new vehicle." On top of that the car was purchased with borrowed money. Money that is owed plus interest.

A credit card allows us to purchase goods and services and pay a "minimum" monthly payment. The payment is very affordable. The problem is that the interest is compounded daily. That means when we make the minimum payment due we have a balance left that is accruing interest daily on the unpaid balance and the balance continues to get bigger not smaller.

A home mortgage is a simple interest loan on an appreciating asset that we can get a tax deduction on the interest paid in the tax year. Assuming that the property will appreciate to a value that exceeds the amount of interest paid over the life of the loan. The idea of a tax deduction is a great selling feature but again the interest paid over the life of the loan is much more that the tax deduction and the appreciation of value combined. NOTE: The house that you live in is not an asset. It's a necessity. It's better than renting but it can not cash flow. If we were to buy a modest house, pay it off and then invest the amount of monthly payment in an interest bearing account, we can make more than the tax deduction would save. It's how the rich get richer.

I believe we have become a society that buys on emotion and the ability to make the monthly payment with out caring what the overall price paid actually is. If we were to save for the car and the house and "live with-in our means" we would be far better off.

I read an article this week that said that 54% of Americans carry a credit card balance of more that $15,000. Another story was on the current mortgage situation where a lady was losing her house. She couldn't make the monthly mortgage payment. When we got further down into her story she had $40,000 in credit card debt, $60,000 in school loans and a car payment. The $900 +/- mortgage payment was not the problem here. It was the out of control spending.

The mortgage crisis is not really a crisis. Yes it is a problem that has grow to exponential proportions, but it is because of home buyers were able to buy homes way out of their price range. The payments were affordable at the time of purchase. Low interest rates, Adjustable Rate Mortgages (ARM's) and interest only loans are just a few of the products offered to home buyers to entice them to purchase more home that they could afford. Then, life happened. Companies downsized, the kids got sick, the tickler period on the ARM loan came to an end before the homeowner could refinance the loan to a fixed rate. Yes, the mortgage companies are to blame so is Wall Street, unethical mortgage brokers and the general American public buying the biggest and most expensive home with a monthly payment they could afford at the time of the emotional purchase.

That is all Bad Debt.

There is such a thing as Good Debt. Good debt allows a business owner enough working capital to make monthly overhead payments while building a business that will eventually produce a positive cash flow. An interest only loan allows a real estate investor the funds to purchase and rehab a property to sell at a higher price and thus make a profit greater than the interest paid on the loan. An investor can also have a mortgage on a property that is rented out to tenants for more money than the mortgage payment. This is called a positive cash flow. A lease payment, be it for a building, vehicle or equipment can be either bad debt or good debt. Consult a competent CPA before leasing anything.

Operating a business or buying property requires capital (money). Borrowing this capital, even with a high interest rate gives the business owner/investor leverage. This is referred to as using money to make money or using Other People's Money (OPM).

The biggest thing that gets under my skin is that we are not teaching our children about finances. How could we? We have become comfortable with living paycheck to paycheck. We should be teaching our teenagers how to balance a checkbook, what a balance statement is and how to read one instead of allowing them to be bombarded with multiple credit cards with ungodly limits. By the time kids get out of college they have acquired so much debt that they spend the rest of their lives just trying to get their head above the water. We need to teach them to pay with cash. Save for that new or used car. Here's an idea you don't hear too often - if at all. Get a loan (good debt) to purchase an asset that produces enough free cash flow to pay for that new car, house, boat or what ever it is we desire.

Remember if you want to live like the rich, you have to live like the rich. They don't accumulate bad debt.

Zig Ziglar said that You don't "pay the price" for success - you enjoy the benefits of success.

There are two excellent learning games that teach financial literacy. One is the Millionaire Maker by Loral Langemeier and the other is CashFlow 101, 102 and CashFlow for kids by Robert Kiyosaki.