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Empire of debt - what's the difference between good debt and bad debt?

The Difference Between Good Debt and Bad Debt

by Roman on January 29, 2009

For most people it is difficult to put themselves in someone else’s shoes but for some reason I have always found it quite easy. They say that trying to look things as other people see them is a common characteristic for Libras!

I have to confess though that sometimes it is difficult for me to understand why other’s don’t realize the obvious! If I take something for granted I tend to forget that this might not be the case with someone else.

Some time ago I had a chance to play the famous Cashflow board game by Robert Kiyosaki. It was my first time!

While I was surprised how easy the game was (I was waiting for more of a challenge) – I was also surprised to see smart men and women doing very stupid choices! For them the game was very difficult – they couldn’t understand why they didn’t make any progress.

The main reason seemed to be that they did not understand the difference between good debt and bad debt.

The difference between good debt and bad debt?

Debt can be used in 2 ways:

  1. To purchase something that you want or need. For example a big plasma screen TV.
  2. To purchase something that helps you make more money. For example an apartment to rent out.

If you buy a new TV with your credit card, you will need to pay for the amount of the TV plus the monthly interest but at the same time you can not use your TV to make any money. Therefore the debt used to buy the TV is bad debt – it only takes money out of your pocket.

If you take a loan to purchase an apartment and rent it out – you will get an additional income stream. That way the debt is not used to make your life easier or for your entertainment (think TV) but as a means to make you more money. This is good debt.

For me it is difficult to grasp that a lot of people are unable to make that distinction and keep using their money in a way that makes them spend even more by having to pay interest or buying something that means additional expenditures!

Good debt

Good debt is often also referred to as leverage – it means that you are taking a loan in order to make more money in the future. Leveraging your money is a great way for people with little money to make big things happen. For example when you start a business that is funded 10% by your money and 90% by the banks money – your own dollars will be making a lot more money than when you fund the entire company yourself. This is basically because with the 90% of the banks money you are able to start a company on a larger scale and therefore make more money.

Here are some things that can be considered as good debt:

  • Taking a loan to buy a house or an apartment for renting it out
  • Buying a car in order to start a taxi service
  • Buying a car to start a moving business
  • Buying a computer to set up your home office for your newly started company – the computer must be essential for the business to function!
  • Buying a stake in a company that regularly pays you dividends.

The difference between good and bad debt can sometimes be tricky! The exact same things bought by different people can be considered both good or bad debt – depending on what they are used for.

Bad debt

Oh no - bad debt!

It is my experience that a lot of people have trouble recognizing some forms of bad debt. Consequently they make some bad investments that seem like good ideas but actually aren’t.

Here are a few things that are  sometimes incorrectly considered as good debt:

Taking a loan to buy a house

For some reason a lot of people think that since they need to buy a house anyway it should be considered as good debt. They feel that because the price of the house can go up (instead of down which seems to be the case lately) it is an investment.

Wrong! Your house does not generate any extra income. In fact – by buying a house you will instantly get several extra expenditures that must be taken care of. By buying a house you also buy a lot of regular expenses! Getting a house can only be considered as good debt when you rent it out or use it for something that makes you money. Financially speaking it actually makes sense to get the cheapest house possible.

Leasing a car

The same thinking goes here as well – “I need a car anyway”. A car can only be considered as an investment and therefore as good debt when it is bought in order to make you more money. Most people say that “Without my car I wouldn’t be able to go to work and therefore my car is essential for my income – thus it’s an investment”.

Wrong! However uncomfortable – most people could probably use a form of public transport to get to work. If you buy a car to drive to work you do not need a new and a fancy one – the cheapest one that drive’s will do. Anything more expensive than that is a bad investment and when bought on credit – considered as bad debt.

Buying collectibles

The prices of collectibles usually go up with time. That makes some people believe that if they use their credit cards to buy a rare coin or a comic book  or etc – it can be considered as good debt.

Wrong! Although it can turn out to be a profitable investment it is still bad debt! The only way that buying a coin on credit can turn out to be a case of good debt is when you start showing the coin for money and therefore get a new income stream!

If you still don’t understand

If you read this article but have trouble distinguishing bad debt from good debt you only need to remember the following:

Good debt – Gives you an extra source of income that you did not have before.

Bad debt – Gives you something that can be useful but does not give you an extra source of income. It only takes money from your pocket.

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Nick January 30, 2009 at 7:02 pm

I’ve never even heard of that board game. Where did you come across it as I think I might like to check it out!

Roman February 3, 2009 at 11:15 pm

I think you can buy the game at Amazon but it is very expensive – about 200 or 300 bucks!

There are also a number of “Rich Father Clubs” across the world – I don’t know what they are exactly called but if there is one in your town go and check it out.
These clubs are free and they allow you to play the Cashflow 101 boardgame.

That’s also where I played it – in an official Estonian Cashflow club.

Whatever you do – try playing it at least once before spending the money!

Nick February 4, 2009 at 8:05 pm

Yikes! That’s a little much for a board game. I would like to try it sometime, but for that price definitely think you hit the nail on the head about playing it at least once before buying it. February 4, 2009 at 1:24 pm

We have Cashflow and have been playing it for years. Our kids especially love playing it these days! I highly recommend Kiyosaki’s book Rich Dad, Poor Dad for a complete explanation of the concepts Roman discusses in this post. We look at all our purchases and debt in this way and are on the way to creating wealth in the process!!

Roman February 4, 2009 at 1:59 pm

Nice to see that the game is really benefiting your family! Giving your kids a good financial education could be worth millions!

Car Insurance Phi June 17, 2009 at 6:50 pm

It’s easy. Good debt can someday make you money (even if only potentially).

Roman November 2, 2009 at 10:58 am

Exactly – you got the point!

mikro January 14, 2010 at 12:39 am

It more on the cash flow focus strategy rather than the inherit value of the investment.

But the real world always not the same, if you manage to buy a property and sell it in 2 year time with 30% of the income and still discounted it back to present value, it better than the yield of property with rent but capital appreciation of 5%.

This is just my taught, since the board game focus so much on cash flow and not much on equity.

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