Debt sucks. It eats away at huge chunks of the hard-earned money coming into your bank account every month and festers in the back of your mind. With mounting student loan debt, more and more young people are entering the workforce with colossal student loan payments and lower than expected salaries. Being burdened by this debt so early on in adulthood has birthed the debt freedom movement and made debt the financial villain for many young people. But is all debt actually bad?
There are two types of debt and the first is consumer debt, AKA bad debt. This type of debt is used to buy depreciating assets, which are assets that go down in price over time. Your car is a great example of this. When you buy a car, you pay a higher price for it than the price you’ll be able to sell it for in the future, which means it depreciates in value.
There are two ways you can use consumer debt to buy depreciating assets, with credit cards and with loans.
Credit Card Debt
Credit card debt is the absolute worst type of debt you can get yourself into. It includes bank credit cards and store credit cards. The reason it’s so bad is because credit card companies charge exorbitantly high interest rates.
The average credit card APR or annual percentage rate is about 16%. For reference, the stock market returns 10% on average every year. If you carry a balance on a credit card that has an average APR, you’ll pay 6% more in interest every year than you’d make from investing in the stock market. Since it’s nearly impossible to find investment returns that will consistently beat your credit card APR, you should prioritize paying off your credit card debt before investing and make your payments as often as possible.
Making frequent payments is important because your credit card interest is charged to your balance and compounds every single day. If you carry a balance, make payments on your card as often as possible to minimize your interest charges.
Consumer loans consist of auto loans and personal loans that are used to buy depreciating assets. As I mentioned earlier, cars are an example of a depreciating asset because they decrease in value over time. If you use a loan to buy a car you pay the sticker price of the car plus the interest, which means you actually end up paying more for the car than it was worth when you bought it. Because you can’t sell it for a higher price in the future and you end up paying more for your car when you finance it with a loan, auto loans are considered a poor choice of debt.
There is a caveat to this though, which is that using a car loan to buy a car you need is better than not buying a car at all. While on paper, auto loans aren’t the best decision, cars provide you with reliable transportation to work, school, the grocery store, and many other places. Spending a few thousand extra dollars in interest to have reliable transportation is well worth it.
When it comes to personal loans, these can be in both the good and bad debt camps as well. If you’re using a personal loan to fund a wedding or vacation, that’s a bad idea. If you already have high-interest debt like credit card debt and want to reduce your interest rate, you can refinance using a low-interest personal loan, which is a great idea.
In general, if you’re using the loan to buy things you want but don’t need, you shouldn’t use it. If you’re using it to buy a necessity or refinance at a better rate, it’s probably worth it.
How to Avoid Consumer Debt
Save more money! It isn’t fancy, but it’s true. An emergency savings is the best way to avoid getting yourself into consumer debt, and that’s because many people don’t run up balances on their credit cards because they have a shopping problem. They do it because they get into a tough situation when they lose their job or have a large medical expense, and they have no way to pay their bills other than to charge them to a credit card.
This goes without saying, but saving more is also the best way to avoid taking out a car loan or a personal loan to pay for your wedding. You should be saving for any large purchase that isn’t a necessity so you can pay for it in cash.
You’ve waited this long, so here it is, the good type of debt! Non-consumer debt is considered “good” debt because it is used to buy appreciating assets. Unlike depreciating assets, appreciating assets, like a house, increase in value over time. Since interest rates are so low right now and have been for the last decade, it has been relatively easy to buy assets with annual increases in value that exceed your interest rate. This is the ideal scenario to be in because you’ll be earning more from your asset than the extra interest you’re paying for it.
Even better than buying your own house with non-consumer debt is using it to buy an investment property or start a business that will grow your income. For example, if you buy an investment property using an FHA loan you only need to put down 3.5% on the property and you can immediately start generating income from it. Because your down payment is so small (relative to the total cost of the house), this frees up extra money for you to use to purchase more income-generating assets. Here’s an example.
Let’s say you want to buy an investment property for $250,000 with an FHA loan. To do that, you only need to put down $8,750 as your down payment and can start making income from it immediately. This dramatically shortens the time it takes to purchase an appreciating and cash-flowing asset rather than if you had to save the full $250,000 or even for a 20% down payment of $50,000. Because moves like this increase your income, they’re a smart way to use debt and build your wealth.
- Good uses of debt
- Buying an asset that increases your income
- Buying an appreciating asset
- Buying a necessity
- Refinancing at a lower interest rate
- Poor uses of debt
- Buying depreciating assets
- Buying wants like weddings, vacations, clothes, etc
So, to answer the question of whether all debt is bad. The answer is definitely not.
For more information on how to buy your own investment property and start making money on day one, check out the book Hold.