Unless you are a newborn, or have been living inside a cave in a deep jungle for a long time , you may have already heard about and have been in debt before.
Debt simply means that you owe money to someone or an institution.. like a bank.
For most of my life, I have been thinking that debt is a bad thing. After all, who wants to be constantly owing money to the bank. right?
It was only after reading a significant amount of books and articles, I realized that not all debts are bad. In fact.some of the debt can be used to even earn money. With this realization, I wish to share the new perspective I have learned about debt and give a brief write up about the different types of debt and how we can determine whether the debt we are taking on is a good/bad debt
What is good debt?
As the name suggests, Debt can be good at times and you can use debt to help your journey to financial freedom.
Good debt helps to bring more money into your account as active income/passive income.
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Business Loans
For example: You took a loan to fund your business growth and injected the amount to grow the business. Once you are able to successfully execute the business plan, be it for expanding to another location or to provide more services/value to your customers. You are expecting these to bring future revenue and profit to the company. It will eventually put money into your account. Therefore, this can be considered as a good debt, the cheaper the interest rate/cost of borrowing the better.
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Mortgage loan on property to rent out
Another example would be, taking a mortgage loan at a cheaper interest rate from the bank to purchase/lease an investment property (Not the house you are living in) to rent out to good tenants, if the cost of borrowing is cheaper say – 1.5% per annum and the property can provide a rental yield of 4% per annum, you are essentially generating 2.5% free cash flow – Again, this free cash flow is coming in to your account and will offset the cost of borrowing from the bank. This only makes sense if you can receive a yield above the cost of borrowing and other expenses to upkeep the premises etc.
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Car loan to rent out cars
While owning a fancy car with the help of a car loan is bad debt, if you purchased the car to rent-out and earn a passive income on a monthly basis, this can be considered as a good debt. Only if you are able to cover the total monthly expenses from owning the car is covered through the rental. Example: Rent from a car is 1000$/Month and the expenses are 700-800$ a month (EMI+Insurance+Tax+Servicing.. etc). This arrangement will provide you a cash flow of 200$.
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Low interest student loans
Low interest student loans can be considered as a good debt. Not everyone is fortunate enough to get scholarships from education institutions/get the education funded by their parents. For the rest of the population, education/student loans are the go to solution to fund the education. Spending for education is considered as one of the most valuable investments you will ever make in your life. You are spending money at your younger ages to graduate with a recognizable degree certificate and potentially be accepted by a company to work for them. I consider this as the greatest investment you can ever make – the more you learn, it will compound the knowledge and your potential to add value to your employers and others around you.
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Other low interest loans
Other Low interest loans taken to increase future earnings can be considered as a good debt too. However this is not meant to spend on investment ideas of any speculative nature (Crypto currencies/Meme stocks).
General rule of thumb is to make sure that the cost of borrowing is lower, and the deployed borrowed amount can create an income that is greater than the cost of borrowing (Principal+interest payments).
What is bad debt?
Since you have already read the above section, you probably already got an idea of what is good debt. Yes, it’s the opposite of bad debt.Bad debt takes money out of your bank and it is always in one direction only, going out of your account on a regular basis. These bad debts can keep you poor for the rest of your lives and give you difficulty in achieving financial freedom.
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High interest car loans
You may be wondering – haven’t i already seen car loans in the above section of good debt and why am i seeing it again here, have the writer lost his mind? To answer this question – I’m still writing this with sound mind. Car loans will be considered as a bad debt because a car is a depreciating asset and is purchased for your own consumption, it starts to lose its value the moment the wheels start to turn.
Car ownership can be extremely costly in countries like Singapore, and before you consider purchasing a car any way – think also about the different types of fees you need to fork out regularly.. Like the parking expenses, maintenance and servicing costs, expensive insurance and road taxes. Cost to replace the wear and tear.
If your situation demands you to own a car.. Like family members with physical disabilities/old age, or living in a place where there are no alternative modes of transportation that can be taken economically – consider buying one that is cheaper and does not require you to pay too much to own and maintain, after-all – the primary reason for owning a car is to get you from point A to Point B.
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Credit card debt
Credit card debt that arises from not paying the bills on time. While credit cards can be of great use and utility, it can also become a double edged sword. Only use credit cards to spend on expenses that you are able to pay back at the due date.
The moment you miss the payment date/only pay a fraction of what you are owed on the card, the bank will start to charge you an astronomically high interest rate of 25% or more in most of the countries.
Before you sign up for credit cards and such credit facilities, ensure you read through the consequences of not paying on time, different rates and arrangements.
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High interest student loans
Student loans – if they are high interest, similar to car loans, education loans become a bad debt too – if the interest rates are too high. Many countries charge higher rates of interest that are not in line with how much a fresh graduate can make out of his first job.
Since, formal education is still needed. Before you take on loans to fund your education, compare the different education loan rates that the different banks are offering and choose the one that makes the most financial sense to you.
Why should you avoid bad debt?
Now that we know what bad debt is, let me take some time to add a few points on why we should avoid bad debt as much as possible.
In the bigger picture, having money going out from your accounts will never make you rich, especially when the total outflows from your account is > the inflows.
This definitely affects your ability to achieve financial freedom.
In the short term, having too much bad debt can put you in serious cash flow issues in the short term too, if some urgent expense comes up. You will be in a crunch until you figure out other funds to tide over the situation.
Missing out on opportunities, we all know that the cost of missing out on some of the opportunities are pretty high, we all come across great opportunities in life and realize “Only if i had that extra $$ i could have grabbed this opportunity” – which sometimes can be life changing.
How to get rid of bad debt?
If you are troubled by bad debt, you can plan your way out of the situation.
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Consolidating your loans
In some countries, like Singapore – Banks allow customers to consolidate the different loans you have with other financial institutions, this bank will pay up other banks and you will be only owing to one bank, now – devise a plan to pay up this consolidated debt as quick as possible, this also helps you psychologically when you realize that you only one to one bank now.
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Focusing on smaller loans first (snowball method)
You may focus on paying off the loans that have smaller sums and reduce the total number of loan (of course don’t miss the minimum payments on the other loans to prevent them from chasing after you). You may attack the giant, once you are done paying up some of your loans in full.
This way you will have all the money to start paying off the bigger loans, you will see the principle decreasing at a faster pace and this will give you more confidence to charge at this monster debt.
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Focusing of high interest loans
The other strategy you can adopt is to focus on paying off the loans with the high interest loans.
I consider this as the best way to proceed, this way you are reducing the total cost of borrowing across all your outstanding loans while staying on course to eliminate the bad debt.
Example: you get rid of that expensive credit card dues which is costing you a significant amount of money.
Conclusion
One thing to always remember is also to consider the interest rate of different loans/debt you take on.
Because not all countries have cheaper interest rates for the different types of loans. For example, India has a higher rate of interest on education loans, compared to Singapore.
I hope I was able to provide you some insights about the good and bad debts you may possibly be taking on – in the future, keep these concepts in mind and come back to visit when in doubt.
Having an understanding about these good and bad debts will definitely help you in your future decisions that matters to your financial freedom.