Understanding Debt
Debt is a tool — like a knife, it can be useful or harmful depending on how you use it. Good debt helps you build wealth or increase your earning power. Bad debt finances consumption and depreciating assets at high interest rates. Knowing the difference is crucial for financial success.
Good Debt
- Mortgage (3-7%) — Builds equity in an appreciating asset. Tax-deductible interest. Leverage amplifies returns. The key: buy what you can afford, not the maximum the bank approves
- Student loans (4-7%) — Increases earning potential. College graduates earn $1.2M more over a lifetime on average. But choose wisely: $200K in loans for a $40K/year career is bad math
- Business loans (5-10%) — Funds a business that generates income. Only good if the business revenue exceeds the loan cost
- Real estate investment loans (5-8%) — Finances rental properties that generate cash flow and appreciation. Leverage magnifies returns
Bad Debt
- Credit card debt (18-28%) — Finances consumption at the highest interest rates available. A $5,000 balance at 22% costs $1,100/year in interest alone
- Car loans on new cars (5-10%) — Finances a depreciating asset. A new car loses 20-30% in year one. Buy used, or save up and pay cash
- Payday loans (300-500% APR) — Predatory lending that traps people in cycles of debt. Avoid at all costs. Even credit card debt is better than payday loans
- Personal loans for vacations/lifestyle — Borrowing to fund experiences that are gone once the trip is over, while the payments last for years
- Store financing / buy now pay later — Encourages spending you cannot afford. Deferred interest plans charge retroactive interest if not paid in full by the promotional period
The Debt Priority Rule
- Priority 1: Eliminate all bad debt (credit cards, payday loans, personal loans)
- Priority 2: Maintain good debt at manageable levels (mortgage under 28% of income, student loans with positive ROI)
- Priority 3: Strategically use leverage for wealth building (real estate, business) only after emergency fund and bad debt are handled