#38 Use good debt wisely, get rid of bad debt completely.

Most people have some form of debt.  Credit card debt, student debt, mortgage debt, car loan, family loans, investment loans, payday loans, rotating lines of credit, and consolidation loans are probably the most common types of debt.  People typically use debt to buy something when they don't have the money for it at that given moment in time.  We as a society don't often save up for things before we buy them, but rather buy them and then pay back the loan over time... that's just the way most people do it these days, particularly younger people just starting out who have no savings to begin with.  The problem with debt is that if taken on for the wrong reasons, or if handled irresponsibly, it can make your life more difficult rather than easier.

But not all debt is bad.  We are quite comfortable taking on large amounts of debt but we only take on what we consider to be "good debt" and that brings us to defining good debt vs bad debt.  We use a fairly simple definition but it has some room for subjectivity.  Good Debt results in a better longer-term fiscal situation for our family as a whole.  Bad Debt results in a worse fiscal situation.

Another way of looking at it would be asking the question:  Does the cost of paying the interest plus the principle make up for it FINANCIALLY in the long run?

Here are my thoughts on what are good types of debt and what are bad.

Credit Card Debt - Bad Debt.  Interest rates are too high and most people use credit cards to buy things that depreciate over time.  If you don't pay your credit card off quickly, the interest will eat up a lot of your money.

Student Debt - Generally Good.  Assuming you are using the the associated education to make more money than you would without the education, then yes Student Debt can be Good.  Once you're done your education, I advise to pay off student debt quickly.  I would however challenge people taking "basket weaving" classes whether those types of diplomas/degrees are worthwhile for the money and interest that they are required to pay back, often for years and years. 

Mortgage Debt - Generally Good Debt.  It allows you to choose where you live and how long you live there by owning property.  Its debatable whether a home is an investment, but the benefit of being in control of where you live and knowing that rent wont be going up every year can help you budget your money more easily.

Family Loans - Generally Bad Debt.  Owing a family member may make sense in some cases, but I'm not a fan of owing family simply because its awkward and usually one side feels they're not getting the treatment they'd like. 

Investment Loans - Good Debt.  If you can make more money on the investment than you are paying for in interest costs, this is definitely good debt in my books.  We regularly use investment loans as part of our investment portfolio.

PayDay Loans - Definitely Bad Debt.  Essentially legal loan sharking. 

Rotating Lines of Credit - Depends on the usage, but I would bet most people are using it for consumer spending.  If you use it for investing purposes, then a Line of Credit can be good debt.

Car Loan - Bad Debt.  New Cars depreciate like crazy the first few years.  Buying a car may be a necessity, but we prefer to pay off car loans very quickly or don't have a loan at all.

Consolidation Loans - Bad Debt.  Usually the lesser of the evils of loans in that consolidation loans usually have lower interest rates than other high interest loans such as credit cards or some car loans. The downside is that this often still consumer debt, just at a different rate.  Pay it off.

Kim and I both had student loans in the 10s of thousands of dollars, which we paid off within a few years once I started working. At present, we have an investment loan and we will be buying a house next Spring which will mean we will have a mortgage again.   Both of these loan-types will help better our financial situation and so we are quite comfortable having them and generally not in a hurry to pay them down.  We have no other types of debt at the moment and we intend to keep it that way.  Whenever we've had other types of debt, we've work very hard to pay it down as soon as possible.  By only having debt that helps our financial situation and doesn't hurt it, it means we don't fuss over our debt as much as other people, and we know that by paying the debt off, we aren't merely pouring our money down the drain, or lining the pockets of others.  We obviously need to make sure that the amount of good debt we have remains at a manageable level that we can be expected to be able to cover with our monthly income.  That is where budgeting comes in.  

Rule #24 Borrow money for things that appreciate, pay cash on things that depreciate.

"The price of borrowing money is interest—and worry. Keep all borrowing below the worry point and don’t borrow to buy things that depreciate; you will lose on both ends." - Ron Muhlenkamp from his Basic Maxims I Want My Kids to Know.

Cars, vacations, iphones, new bicycles, dinners out at restaurants etc... all lose their intrinsic value the second they are purchased.  Yet people put them on credit cards or take out loans to buy them and carry the balance for months or even years.  So not only is that meal you spent $100 on long gone, but you are now going to pay an additional 10-20% (or possibly more) because you didnt pay it off right away.  Bad idea, Genius.  One of our rules is that we don't buy anything on credit or loan if it depreciates over time.  We view paying more to buy something by spreading the payments over time for something that goes down in value as a silly thing to do.  I know people who buy stuff on credit cards because an item is on sale and then don't pay it off for up to a year or more, essentially negating the sale price.

But the biggest sting is on big ticket items... so let's look at a big ticket example.  One that most people can relate to would be a car purchase. Suppose you bought a car for $25000 and you financed 100% of it for 5 years at an interest rate of 5%. You'd pay about $471 a month in payments.  The car will depreciate 10-15% per year depending on make and model.  For this example, lets assume 15% depreciation.  After 5 years you are still paying the $471 per month, but your car is now only worth a little over $11000.  When you finish paying for it, you will have paid about $28306 once you add in all the interest.  By paying for the car in full at least you would avoid paying the extra $3306 in interest.  A big part of my apprehension is psychological. I recognise this, but I still think its worth thinking about,  You will pay $5600 in the final year in monthly payments, and your car will only be worth the equivalent of 2 years worth of payments...  yeah, that stings.

What if you did without a car for a few years and saved $471 up front each month, how long would it take to save up the 25000 in cash?  Lets also assume you can get a 5% return on your savings. According to this handy online calculator, it would take 48 months to save up 25000 to pay for the car in cash.  You would actually only have to put up $22600 of you own money, and the compounding at 5% per year would do the rest.  You've saved yourself $5700 dollars and you own the car outright.  You can keep saving $471 in your account for your next car that you will pay for in cash.  Since we know you can probably replace your current car for $25000, you will be able to save up the money for your next car in 4 years!  This is generally how we operate.  Save and then buy.  Not borrow, buy and then pay down.

But I'm not against borrowing.... I just dont like to borrow on things that depreciate.   I do however like to borrow money for safer investments or assets that provide some cashflow.

Lets look at borrowing to invest in something that appreciates in value, rather than depreciates.  (NOTE: you should know by now that I don't usually fuss too much over capital appreciation in the short term, but for this example lets assume that capital appreciation is the goal.  We will also not consider taxes for this example even though I know taxes will take some in the end if you sell the investment)   We will borrow at 5% and buy a $25000 investment that appreciates (and therefore compounds) at 5% a year instead of depreciating like the car.  After 5 years, you will have paid the same as the car, $28306, but now the investment is worth $31,907.   So in the case of borrowing to buy a car vs investing, I could borrow to buy a car that will cost me 28k over 5 years and then its only worth about 11k when I pay it off, OR I can borrow and pay the same amount over those 5 years on something that appreciates over time and it would be worth about $3600 more than what I paid for.  So to compare both scenarios with their bottom lines, the depreciating car has lost about $17300 of what you've put into it, and the investment is up $3600.  That's a difference of nearly $21000.  Well, when you put it that way Ryan, that IS a huge difference.

This is the way we've set up a portion of our finances. We only borrow for things that increase in value such as investments, and we save up to buy all things that depreciate.