Personal finance is a tricky thing. It would be nice if it were as simple as working hard, earning money, and spending less than you earn — but the reality is that this formula, while a great place to start, is far too simplistic.
The problem is debt. Debt can complicate just about any long-term financial strategy. But avoiding debt isn’t an option, at least not if you want to use valuable asset to grow your net worth. Without debt, you won’t be able to use a credit card at the gas station — much less buy the car that you need in order to get to your first job.
Understanding debt is key to mastering your personal finance strategy. Let’s talk about debt, what it’s good for, and how to minimize it while maximizing its usefulness to your long-term wealth strategies.
Good debt, bad debt
Perhaps the single most important thing to understand about debt is that there are two general types of debt: good debt and bad debt.
Any time you borrow money, whether it’s a long-term loan or a quick charge on your credit card, you’re asking the person or organization lending it to you to take a risk. If you don’t pay them back, they lose their money So debt has interest, which means that you’ll pay back more than you borrowed (usually, anyway — sometimes, you can do things such as pay off your whole credit card balance before interest kicks in).
When we talk about bad debt, we’re talking about high interest rates. When interest is too high, you can struggle to pay it off — meaning you’ll have a hard time even touching the principal, which is the amount that you originally borrowed. Generally, short-term loans have higher interest rates. Credit card debt is a great example of bad debt.
“Good” debt has better interest rates and, ideally, serves an important purpose. The ultimate example of good debt is a home loan or a mortgage. When you pay into a mortgage every month, you’re not doing anything all that different from paying rent — except that this expense goes toward your ownership of a valuable asset, your house. And because the loan is effectively secured by the house as collateral (in other words, the bank will take your house if you stop paying), there’s less risk for the lender, and interest rates tend to be lower. The long-term nature of a mortgage keeps interest rates low, too.
Using debt wisely
Is all debt “good” or “bad?” No, not exactly. Take car debt, for instance. Cars, unlike real estate, will not appreciate — generally, they’re going to drop in value over time. Plus, car loan rates aren’t quite as good as mortgage rates. But the good news is that car loans are secured (if you don’t pay, the lender will repossess your car), so that keeps interest rates down a bit. In the end, we have a mixed bag. If you can pay cash for your car, you may not have to take out a loan, and that’s good. But if you need wheels to get to your first job, then you may need to take out some auto debt, and that’s OK too.
So, in this case, using debt wisely doesn’t mean limiting all debt to things like mortgages. It just means being smart about how much debt you take out. Shopping for your car may mean skipping luxury car dealers and Googling “car auction near me.” It may mean finding a great deal online instead of splurging on some over-the-top ride.
Even with good debt, you’ll want to be careful. You can, after all, default on a mortgage. But once you understand the power of debt, you’ll start to see how you can use it to actually grow your net worth. Buying your own home gains you a great asset, but what about buying another property? Landlords use investment property loans to acquire valuable real estate properties that they can then rent out and reap passive income from, or resell at a higher price later. You can do all this without ever actually having all of the money that the house is worth.
Again, you need to be smart. A firm understanding of debt means knowing when to target savings and minimize debt, and when to be willing to take out a big loan to start a business or buy a home. Master the difference between good debt and bad debt, and you’ll be on your way to better financial future.
