How To Use Debt Wisely
Most everyone has some debt, some more than others. However, the type of debt you have has a significant impact on your financial situation.
There is good debt and bad debt. You use good debt to enhance your situation and increase your net worth. You should avoid bad debt altogether.
Here’s how to tell the difference between good debt and bad debt. If you borrow money and spend it on something that going to go up in value, that’s good debt. If you borrow money and spend it on something that is going to go down in value, that’s bad debt.
The reason is that debt is leverage. It magnifies the impact of what you spend the borrowed money on. If you borrow money and spend it on things that go down in value, then you pay more for those things that would have if you didn’t borrow the money. But if you borrow money for something that goes up in value, your investment pays off more.
For example, if you put $20,000 down and borrow $80,000 for a home, then you can buy a $100,000 home. If that home goes up 10% in value, then you made $10,000. But the bank doesn’t get any of it. It’s all yours. So while the property only went up 10%, your investment went up 50% from $20,000 to $30,000. Debt is leverage and magnifies the result. If the home had gone down 10%, you would have lost 50%.
The biggest change in how you see debt will come from your understanding that debt is leverage. Everything you use it for gets magnified, good or bad. So when you borrow money for a car that will eventually be useless, you are magnifying the cost. That’s bad. When you borrow money to take a trip or to live beyond you means, you are magnifying that cost too. That’s worse.
While buying a home isn’t what most people want to think about after the recent collapse, mortgages fixed and affordable, are good use of debt. There are always bumps in the road, but if you aren’t trying to flip a house in some get rich quick scheme, real estate is a solid investment. The leverage from the borrowing combined with the tax deductions and your continued paying off of the principal add up to most people’s largest nest egg.
To use debt wisely, borrow what you can afford to pay back, use it to buy appreciating assets, and be in it for the long term. To use debt unwisely, just look around and do what other people are doing.