It’s true that debt is important for several reasons, but, first, let’s define debt. Basically, a debt is when you borrow something (usually cash) from another person to buy a product or service that you cannot afford at that moment.

For instance, let’s say you’re out with your friends. You see a nice pair of shoes that you want to buy. Unfortunately, you don’t have the cash for it at that moment, so you ask a friend if you can borrow some money from them. You promise to pay it back the next  month with 5% interest. However, once you borrow the money, you become indebted to your friend.

The example above talks about debt on a small scale. On a larger scale, debt can constitute auto loans, mortgages, personal loans, and credit card loans, for instance.

But what exactly is the purpose of a debt and why is debt important?

Well, borrowing money usually helps people purchase items that they wouldn’t be able to afford otherwise. Like a home, or a car, or even the financial capital required to start a business. These are all necessary things, but they cost a lot. And obviously, it is absurd to expect people to shell out large amounts at once.

Let’s go back to the first example about the shoes. What if you didn’t just want the shoes, but needed them because the last pair you had was torn, and you simply didn’t have the cash? In that case, you would have had to borrow money because shoes are a necessity. This is the basic purpose of debt.

When is Debt Bad?

Debt can be bad in several instances. Debt has the power to pull you under its weight and cripple you financially. You’re basically spending money that you don’t have, so you’re essentially borrowing from your future income. This borrowing can potentially be debilitating for your future, especially if you borrowed money for non-essential items.

When it comes to high-interest debts, you end up paying a lot more than the principal amount in the form of interests. Debt adds unnecessary stress to your life, reduces your purchasing power, and it also keeps you from achieving your financial goals. Having a lot of debt also hurts your credit score, which can prevent you from getting approved for loans.

But does that mean debt is always bad? No.

When is Debt Good?

Debt can be good when it is used to invest in something where the value will appreciate and generate income in the future. In this way, you will find that debt is important for your life. For example, if you borrow money to start a business, you will probably end up turning over profits soon. In this case, you’ll end up generating income and building wealth, making your debt a good thing.

Great! Now, how do I make debt a good thing in my life? The answer lies in being able to differentiate between good debt and bad debt. Let’s look at how we can do that.

Have you ever heard of the old adage “it takes money to make money?” Anything that exemplifies this phrase is categorized as good debt. This means any debt that has a positive outcome in your life such as increasing your net worth by accumulating assets that appreciate over time or generating income and building wealth.

Good debts also typically have low interest rates and are tax deductible! A win-win!

Here are some examples of good debt:

Education

Debt for education comes in the form of student loans. Education is an investment because the more education you have, the higher your earning potential. A good education will help you grab high-paying jobs, enabling you to pay back your debt within a few years of graduating.

However, not all fields of study are created equal. For example, a data analyst job will pay more than a librarian job. So, before you take out student loans, research your field of study and gather intel on potential salaries. Avoid borrowing more money than the amount you will be able to make in your first year. This is to help you prevent accruing more debt as the years go by.

Mortgage

If you’ve ever considered buying a house, you might have wondered: is mortgage a good debt? Yes, it is, because homes make for great investments and build your net worth in the long run. Home prices also generally increase in the long run, so you can sell it after a few years and make a neat profit.

Even if you don’t sell your home, you’ll always have a place to live that is entirely yours! Another option is to rent it out so that you will receive a steady stream of income every month. Leveraging your home equity is a third option to build wealth using real estate. But keep in mind that prices don’t rise indefinitely, so don’t borrow more than you can afford to pay off.

Business Loan

Whether it is to get a start on your business or simply expand it, business loans are a great idea. Even if your business doesn’t end up becoming the next Amazon, with a proper game plan, you can still make a decent profit.

Debt is also cheaper and less risky than equity because shareholders will expect a return on their financial investments. The interest you pay is also tax deductible.

What is Bad Debt?

Money that is borrowed to spend on a depreciating asset is known as bad debt. This means its value won’t go up with time, generating no income for you. Moreover, when you pay it back, you will be emptying your pockets on something that has very little value.

Here are some examples of bad debt:

High-Interest Credit Cards

The interest rates for credit cards are some of the highest, going well into the double digits. If this wasn’t enough, the debts often take years to pay off in full.

Additionally, credit card debts don’t constitute an investment since the majority of the purchases using credit cards include clothes and other consumables. So, as a general rule of thumb, do not go into debt to buy things that aren’t absolutely required.

Debt vs. Credit

Debt and credit are both related to borrowing money. Credit is the money you borrow, while debt is the amount of money you owe after borrowing. There are three types of credits, but the ones that are used to take out loans are revolving and installment credits. 

Buy Now, Pay Later Apps

Similar to credit cards, these apps let you buy now and pay later. These loans can be dangerous because they lead to overspending and overexerting your pocket.

Many of the users of these apps are not even aware of the rate of interest they owe on these loans! Spoiler alert: they are very high. Moreover, if you don’t pay your installments on time, you could be charged with a late fee, or worse, turned over to debt collectors.

Loans From Work Pay Stubs

Also known as payroll loans or cash advances, these are short-term loans that you can receive in a day. They are given by banks to employees who have a salary account with them. The amount is automatically deducted from the employee’s salary in the upcoming months.

The kicker, however, is that these loans have a very high interest rate—often 15% to 30%! They are also usually due within a month of borrowing. In fact, with such loans, the borrower has to write a postdated check for the repayment of the loan. So, if you aren’t able to pay them back on time, things can take a turn for the worse very quickly.

Car Loans: Good Debt or Bad Debt?

This one is a bit tricky. For most people, a car is a necessary means of transportation. But, unlike a house, cars are not really an investment. They depreciate in value as soon as you bring them home. They often turn into lengthy loans, plus you will have to foot the bill for gas as well as any machine-related emergencies that may arise.

But, on the other hand, they let you travel places hassle-free. They also have low interest rates. So, whether your car loans turn into good debt or bad debt, it all depends on you.

[Editor’s Note: Why should debt be so important to you? It’s all part of being in control of your finances. You can use a simple debt repayment calculator to gain control of your debt.]

Tips To Avoid a Debt Trap

• Don’t use good debt to pay off your bad debt. For example, taking out a mortgage on your house to pay off your very high credit card loans.  

• Be wary when borrowing more money to pay off debt.

• Keep an eye on your income to debt ratio. Never bite off more than you can chew.

The bottom line? No debt is better than bad debt, but good debts can become an asset if you manage them wisely. So, why is debt important? Because it can help you build wealth and have a better financial status in the long run.

Editor’s Note: Want to learn more about debt and how it can impact your life? Or want to learn how to plan for your financial future? Check out the book below…

Automatic Wealth: The Six Steps to Financial Independence

Turn your skills and experience into making more money. The best part is that you can accomplish this goal within years — and you don’t have to take big, life-altering risks.