Monday, August 18, 2014

Is Debt Good or Bad?

Some people teach that all debt is bad and should be gotten rid of. Although I believe that is partially true and those who teach this mean well, in the current system we use today, I do not agree with that assessment in whole. There are two kinds of debt: good debt and bad debt. Wait a minute! you say, I thought all debt was bad! Well debt can work for you or against you. The debt that works against you is bad debt, the debt that works for you is good debt.

Our whole monetary system is based on debt. The more debt that people have from banks, the more money they can issue. This is how bubbles are created. Remember the housing bubble? You might think that what happens is that a bank has money sitting in the building waiting for people to borrow it and then when you apply for a loan they borrow it to you. Well, that's not how it works. Banks create this money, practically out of thin air. Banks use a system called fractional reserve banking. What this means, in essence, is that they are borrowing you money that isn't actually there. (I have now decided I want to do that too. I will borrow you money I don't have and charge you interest! But wait! I am not allowed to do that. Hmmmm.) Anyway, for more on fractional reserve banking, See this link or just google it.: 

Here is a quote form the above article: Because the bank is authorized by law to create credit up to an amount equal to a multiple of the amount of its reserves, the bank's reserves on hand to satisfy payment of deposit liabilities amount to only a fraction of the total amount which the bank is obligated to pay in satisfaction of its demand deposits. This is why when people began defaulting on their mortgages in 2007-2008 (some before and after as well up to this day), eventually it had a ripple effect and sent the state of the economy into a crisis and congress voted for a massive bailout. 

So what is good and bad debt?

Bad debt is anything that makes money go out of your pocket every month. Some of this isn't even really "bad" debt, but it is a liability, meaning the cash flow is coming from you and going to somewhere else. Credit cards are an example of "bad debt". If you charge your groceries every month and then pay the minimum amount that is very bad debt and a spiral that will be difficult (but not impossible) to climb out of. But "Bad" debt can be any kind of a loan. Please keep in mind that "bad debt" doesn't mean you are a bad person if you use it, what it means is simply this "Liability" or "Outgoing money monthly". Some bad debts are more useful than others. For example, mortgage debt can fall under the liability category, but you may not want to call that "bad" debt. I call any debt bad debt that is a liability. (So please understand I am not trying to label anyone or anything with these terms. You can categorize these things however you want but for sake of ease, I will categorize them good and bad.) Does money go out of your pocket for a house payment every month? That is bad debt. Car payment? Bad debt. Medical bills? Bad debt.

Good debt is debt that creates cash flow monthly. This means you are using debt to your advantage. If you borrow money to create a business that creates cash flow for you, that is good debt.

So the difference between good and bad debt is that bad debt takes money out of your pocket every month and good debt creates money for you every month. 

That said, it is best to get rid of bad debt as soon as possible. However, sometimes you may want to use your extra cash for capital rather than paying down bad debt if that is more to your advantage. For example, you may want to start a business with your capital rather than paying off your house. Everything must be weighed as to what is most to your benefit.

If you have credit card debt with high interest, or anything with high interest, it is good to get rid of that first. However, psychology does play a factor. If, for example, you have three credit cards. You have:

1. $500.00 owed at 8% interest.
2. $3000.00 owed at 18% interest.
3. $300.00 owed at 15% interest. 

You need to decide if you are happier paying number 3 down first or number 2. Some people, psychologically need to pay down number 3 first so they can feel they've payed one off. And that is fine. Do what works best for you. 

That Starbucks latte? $5.00 towards your credit card bill instead. If you "treat" yourself to Starbucks twice a week, if you cut that out, that's $40.00 a month or so you can use to get rid of that debt. It really does all add up. Happy Savings! :)

No comments:

Post a Comment