Many people think all debt is bad, others think it is okay to have good debt, and still some like all kinds of debt! Is there a difference between good debt and bad debt and what is good debt vs bad debt? Most people will tell you that good debt is debt that is against an appreciating asset like a house while bad debt is on a depreciating asset like most cars or furniture. Other people will tell you that all debt is bad! I am a real estate broker, investor, and author, and while I understand the good debt vs bad debt argument I do not agree with it. I do not think the most important factor when considering debt is what the debt is against, but what you use the debt for. Some people like Mark Zuckerberg, are able to pay cash for most everything but still use debt because they see the value of borrowing at a low-interest rate and investing to get a much higher interest rate.
The no-debt argument
Dave Ramsey has tried to turn the world into a no debt society. He thinks that all debt is bad and no one should have debt if they want to get ahead in life. Dave uses his real estate fails to prove his point but his failure is not even possible to duplicate in today’s world. He was using risky 90-day mortgages on commercial properties to take advantage of a tax rule. That tax rule was changed and he went bankrupt when the banks called his loans due.
The tax rules he was taking advantage of do not exist today and it is very tough to get a 90-day commercial loan for 99% of the population. When you get a traditional rental property loan the term is usually 15 or 30 years but some commercial loans may have a balloon payment due in 5 years which means the loan has a 5-year term. The bank cannot come to call your loans due when things go bad as long as you are making your payments.
I do not care for the no debt argument because it makes it impossible for most people to get ahead in life using real estate. I am a real estate investor and debt is a wonderful tool if used in the right way. I make so much more money using debt than paying all cash. It takes most people decades to save up to buy a property with cash if they are even able to.
Mark Zuckerberg bought a house in 2012 for $6 million when he was worth $15 billion. Even though he was a billionaire he got a mortgage on the home! He knew that he could invest that money and make much more than the mortgage cost him.
Good debt vs bad debt
For those who like debt, there is the argument that there is good debt and bad debt. The argument goes like this:
Good debt is debt that is against an asset that will appreciate or make you money. Rental properties would be an example of an asset that will make you money, but a car most likely will not make you money and most cars go down in value not up. Bad debt would be a loan used to buy a car.
The idea of good debt verse bad debt is that you should only borrow money for something that is an investment. Something that will make you money. On the surface, this seems like a good idea. “Don’t borrow money against things that may decrease in value.” However, I am still not a fan of good verse bad debt.
Why I don’t think the asset matters when it comes to debt
I agree that people can get themselves into trouble when taking out loans and you need to be careful about getting into too much debt. However, debt can be a wonderful tool to build wealth as well. Where I differ with the good debt bad debt argument is that I do not think the asset the debt is against matters.
I think the most important aspect of debt is that you make more money from the investment you use the debt for than the debt costs you. If the debt costs you 5%, the investment needs to make more than 5%, hopefully, quite a bit more than 5%.
“But if you buy a car with a loan you obviously are not making any money from it!”
On the surface this is true. However, I need a car to work and I also have many other cars that I own because I love cars. I am going to buy those cars whether I use a loan or cash. I have the cash to buy the cars if needed, but I get loans on some of those cars because I can make way more money investing the cash, than what the loan costs me.
- I buy a car for $100,000 with a loan that has a 5% interest rate (we assume 100% financing)
- That loan costs me $5,000 a year as opposed to using cash
- If I can make 10% with that money I will make $10,000 a year
Even though the loan is against an asset that may go down in value (many of my cars go up, but most go down), it can be a good loan!
- You need a car for work that costs $30,000.
- You have the cash to buy it, but that means you cannot buy your first rental property.
- The interest rate is 3% which means the car loan costs you $900 a year.
- You have studied how to get a great rental. You are getting an awesome deal that will give you $30,000 in equity, and $400 a month in cash flow.
- That rental could make you more than the car costs in one year!
In both of these examples, it makes more sense to me to use debt to buy the car than to use cash even if the asset may go down in value. I care about how much money the debt will make me, not the asset the debt is against.
What about over-leveraging or bad purchases?
There are limits to this strategy. It is not an excuse to go buy everything because all debt is good. I did not say all debt is good, I said a debt against a depreciating asset can be good.
- If you want to buy a Ferrari but it will put you in a dire financial position, do not buy a Ferrari!
- If you really want a nice couch but the only way you can afford it is to take out a credit card with the furniture store, that is not good debt.
- If you are operating on a razor-thin margin every month but you like the looks of the new Ford Bronco, getting a loan to buy that car is probably not a good idea.
When I talk about using debt on any asset to make more money, I mean that you are actually using the money to invest. Too many people use debt to spend and they never have anything left to invest. If you are in a position where you can’t pay off your credit cards every month, more debt may not be the answer (unless that debt is used to pay off credit cards at a much lower rate).
I do not believe in good debt and bad debt based on the asset that is financed. I do believe there is good debt and bad debt based on why a purchase was made and the borrower’s financial position. Car loans can be a good or bad debt depending on the situation. Even a rental property loan can be good debt or bad debt depending on the situation. Not all real estate loans are a good idea. Just like with most of my advice, there is no one size fits all answer. We are all different, have different goals, and different financial situations. Make sure you analyze your situation and what makes sense for you, not blindly trust people who write articles online. 🙂