Debt is a subject that many people would rather not talk about even though many are struggling with debt. Is having debt a horrible thing? Do you feel like debt is slowing you down financially? Are you overwhelmed by the amount of debt you owe? Perhaps debt keeps you up at night?
If you answered yes to any of these questions, you are not alone! Debt is a common part of life especially in advanced economies like the United States.
Debt is nothing new. Historians and anthropologists have told us that debt predates money. Meaning that ancient societies utilized debt way before money was invented.
Debt can be a powerful tool if you use it wisely. Debt provides a means to do something now and pay for it later, as more income is earned. Debt can be harmless if used cautiously. This has led to the popular classification of debt into good debt and bad debt.
The notion of debt being good or bad has been challenged by various financial coaches in recent years. Rich Dad Poor Dad author, Robert Kiyosaki is a big proponent of good debt. He expressed in his book that good debt is debt that puts money in your pocket. He promoted the concept of using other people’s money (debt) to build wealth.
On the other hand, you have Dave Ramsey who opposes having any type of debt. He encourages his followers to stay away from all types of debt – good or bad. Dave Ramsey shares his story of going bankrupt and bank foreclosures that brought down his real estate empire in his twenties.
Personally, I believe none of these parties are right or wrong. Whether a debt is good or bad for you is dependent on various factors. Such factors include how you plan on using the debt, what you are borrowing the money for, your risk tolerance, payback period, interest rate, personal values and your overall financial goals.
We will explore how to use debt or credit wisely but before doing so, it is necessary to understand the difference between good debt and bad debt as widely accepted.
What is a good debt ?
Good debt on things that increase in value and put money in your pocket. It’s any debt that can help you achieve your goals faster.
- Investment mortgage
- Investment loans – for instance, loans provided to farmers for the purchase of seeds to be planted, then using the harvest to repay the debt. Similarly small business loans to increase inventory, increase returns, scale or growth.
- Student loan
It’s also important to understand that good debt has the potential to turn bad instantly. All it takes is one domino to fall. Thanks to the unreliability of human behavior and uncertainty.
What is Bad Debt ?
Bad debt also known as consumer debt is any debt that doesn’t pay you or put money in your pocket. It is any type of debt that increases your expenses instead of your income or equity. If it doesn’t help you make or save money, avoid it. Never go into debt for depreciating assets. Bankruptcy, foreclosure, repossession and bad credit score are all synonymous with bad debt. Even worse, bad debt will cost you peace of mind, not just money.
Related: Spend Less Than You Earn
How to use credit wisely:
With debt, you have to be strategic if you want to build wealth and achieve your financial goals. I am a huge proponent of avoiding all bad debt or consumer debt at all costs. So from this point on, we will be focusing only on good debt and how to use good debt wisely.
Here are five best practices to keep in mind before taking on debt:
1. Analyze your risk tolerance
With debt it is important to avoid reckless risk-taking. You must assess the potential risks and reward before taking on debt. The better you understand the downside of incurring the debt, the easier it is to determine your comfort level with that risk. Figure out the likelihood and impact of a potential risk when dealing with ‘good’ debt. Then underwrite it and ask yourself if you can handle it. Your goal should be risk reduction or elimination. Ask yourself questions like: can I ride out prolonged market volatility? How soon can I pay off the debt?
2. Never over-leverage
Over-leverage happens when the amount borrowed is too much that repayment becomes impossible or difficult. High debt burdens can leave you vulnerable to a sudden tightening of financial conditions.Think of the devastating effects of unsustainable debt before borrowing. Also, review your cash flow to ensure that you have enough income to service the debt you are about to take on. Over-leverage is not just detrimental to financial stability; it can also become a drag on wealth building efforts.
3. Acquire domain knowledge
Wouldn’t you like to play in a game where you have an unfair advantage? Knowledge gives you an unfair advantage in any chosen field. Being knowledgeable in whatever you are taking on debt for, equips you with the skills necessary to avoid default. Without knowledge you’re flying blind which is a very quick way to turn good debt into bad debt in a wink of an eye. Knowing what you are doing is a big way to mitigate the risk of burning yourself with debt. Strive to acquire the knowledge that takes you from amateur to professional before you take on debt.
4. Start with a proof-of-concept
start small and prove yourself. Before you run you have to walk first. Starting with a proof-of-concept gives you a solid foundation and helps lower your chances of a bad outcome with debt.
5. Create a repayment plan
This practice answers the question: how will I service this debt? Before taking on debt, be certain that you have a solid strategy to pay the money back. The repayment plan is a necessary step every potential borrower must go through to be successful with debt. When creating a repayment plan you will need to take into account the loan structure like interest rate, payback period, grace period, prepayment penalty, income or cash flow, collateral and so on.
Ultimately, how you use debt will determine your financial success. Ask yourself whether the debt you are taking on will make you money or cost you money. Then determine if what you are borrowing for will appreciate or depreciate over time before taking on the debt.
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