Good Debt/Bad Debt: Understanding the Difference Can Make You Wealthy

Excerpt from The Millionaire Real Estate Mindset by Russ Whitney

It wasn't very long ago that debt was considered a shameful thing. In fact, the home mortgage as we know it didn't come into being until the 1930s. Prior to that, if you couldn't afford to pay cash for real estate, you rented.

Through the first half of the twentieth century, consumer borrowing was done on a very small scale. Some shopkeepers extended credit to individual customers on an informal basis, but the norm was for people to pay cash at the time they made their purchases. Smart business owners realized that extending credit inspired customer loyalty and increased sales, and it was that awareness that led to the introduction of credit cards in the 1920s. These initial cards were issued by companies to their customers for purchases made at those businesses. The first universal credit card was introduced by Diners Club in 1950, and bank credit cards came along about a decade later.

Mortgages made it possible for average wage earners to buy their own homes, and that's good. They also made it possible for average people to invest in real estate—an opportunity that was previously unavailable to all but those who were already wealthy. Credit cards reduced the need to carry large amounts of cash and made it easier for people to track expenditures. However, they have also made it possible for average wage earners to get over their heads in debt.

When you have a mortgage on your house, clearly that's debt. When you owe $20,000 or more on multiple credit cards, that's also debt. But there is a dramatic difference between the two. Your house is an appreciating asset that is increasing in value as you pay off what you owe on it. More than likely, what you charged on those credit cards are depreciating assets that are worth far less than you paid for them by the time the bill comes in.

It's important to know how to look at debt properly. Don't be afraid of it—understand it and use it to your benefit. There really is such a thing as good debt. Good debt is money that you borrow to increase your personal wealth, such as loans you use to buy real estate.

What's Bad About It?

Let's talk about bad debt. Every day, you are bombarded with “buy now, pay later” messages. They're on television, radio, billboards, newspapers—virtually everywhere you look. Not only are credit card companies urging you to charge what you want now and figure out how you're going to pay for it later, they're also competing for the debt you already have. How many times a week do you get a pitch for a new credit card with a special deal for balance transfers? By the way, you may be tempted to take advantage of those offers to try to reduce the amount of interest you pay, and, depending on your particular circumstances, that could be a smart strategy. But always read the fine print of the offer very carefully, because it's common for that super low interest rate to be effective for a limited time, or you may have to pay a penalty if you don't carry a minimum balance (on which you are paying interest) for a specific period.

Any money that you owe for something that is not increasing in value is bad debt. Those consumer purchases—dinners out, clothes, household furnishings—that you put on a credit card and pay interest on the unpaid balance are all bad debt. Bad debt is money you borrow to buy depreciating assets, which are things that go down in value as you continue to pay for them. Let me make it clear: I'm not suggesting that you shouldn't go out to dinner, buy clothes, or furnish your home—just don't borrow money to do it. I'm also not suggesting that you not use credit cards. In fact, there are many reasons why you should charge most of your purchases, such as easier record-keeping, rebates, various bonuses offered by the credit card companies, and consumer protection services. Just be sure you never put a consumer purchase on a credit card that you can't pay off in full when the bill comes in.

When Debt is Good, It's Very Good

As I said, there really is such a thing as good debt. If you own a house, your mortgage is good debt because your home is more than likely appreciating in value as you are paying off the loan. If you own investment real estate that is appreciating in value and generating positive cash flow, the money you borrowed to make that purchase is good debt. But if you're still paying off the vacation you took last year with interest, that's bad debt—no matter how much fun you had.