Personal Finance Pillar # 2 - BORROWING - What is Good Debt?

Personal Finance Pillar # 2 - BORROWING - What is Good Debt?

Debt is not inherently bad or good. There are however good reasons for incurring debt and bad reasons for incurring debt.

Your financial goal should not be to grow the biggest pile of cash possible, but rather to get the most enjoyment out of your money, to maximize the quality of your life. Throughout your life, your earnings do not match perfectly with your money needs, which is why society created a system to allow your money to time travel.

Debt allows you to access your future earnings now. Debt is really borrowing from your future self. This is incredibly helpful and does allow you to maximize your happiness now by not having to wait till you can save up enough to buy everything with money already earned. Could you imagine having to save up enough to purchase a house without using debt?

Unfortunately, there is a cost to access your future earnings, and that is interest charges. Time is money and to access your future earnings early means you must pay interest on these borrowed funds. Even still, using debt may be worthwhile if the reason for the borrowing is a good one. Debt becomes harmful if repaying the debt plus interest causes your future self hardship or hinders you from living your best life.

How does one tell if borrowing would be helpful and good debt or harmful and bad debt?

Debt used to buy an investment is a good reason for debt. An investment is any spending now that will allow you to increase spending in the future. It may be physical investments like a home or a stock market purchase. Or it could be investing in an education or a skill or trade. If the spending and use of debt results in an increase in future earnings, then this debt should be a net benefit to you overall.

Debt that will cause a hardship for you when you go to repay it, is bad debt. Debt repayment is not optional and could be a burden on your future self. If your budget is tight and the repayments cause you to struggle to repay this debt, then you will come to regret that you ever borrowed this money.

Debt that carries a high interest rate is bad debt. A compounding high interest rate will make the cost of the debt extremely high and will very likely hinder your future self from living your best life. Credit card debt or payday loan debt incurs very large interest charges and will result in a big burden for your future self.

Debt that prevents you from meeting your most important financial task of investing for your future is bad debt. When you agree to take on debt, you are committing your future earnings to go towards debt repayment. If your future money must be used for debt repayment then it automatically means it cannot be used for another purpose, so there is an opportunity cost to taking on this debt. If the opportunity cost is that you cannot afford to invest for your retirement, then the cost of this debt is very high and is bad debt.

Debt that allows you to spend on something now, that will bring you more joy now than the joy you will get from spending this money plus interest in the future, is good debt. Sometimes we have an opportunity to buy or experience something that is very important to us. While we may have to borrow and pay interest to be able to do it, if it is important and a priority then the cost of the debt will be well worth it. This may be spending on a nice wedding or a once in a lifetime travel experience.

If you are money-smart and use debt wisely, it can be a terrific financial tool and can really enrich your life. But be aware. Thanks to compound interest debt can grow very quickly on its own. Debt is so easy to get into and very difficult to get out of. If you incur too much bad debt it will take away your freedom and your ability to choose what you do with your future resources, and prevent you from living your best life.