What are differences between the good and bad debt?

Question

Mike McKinzie · Answer

When I teach individual Financial Management, one of my first rules is, "Never go into debt on a non-appreciating asset".  Zero percent debt is not really debt, just delayed payment.  I LOVE zero percent and have bought lots of things on zero percent financing.

While most real estate has not appreciated over the past 3 years, I would guess most houses are worth MORE today than they were 10 years ago.

Wikipedia defines it this way:  A bad debt is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed. This usually occurs when the debtor has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself.

The debt is immediately written off by crediting the debtor 's account and therefore eliminating any balance remaining in that account. A bad debt represents money lost by a business which is why it is regarded as an expense.

This type of bad debt is when money is owed you and you will NEVER see it.  Think FORECLOSURE.

But others have posted, if debt COSTS you money, it is bad.  If debt MAKES you money, it is good.

Jon Holdman · Answer

If you can buy a rental property that has real postive cash flow even with a mortgage in place, then that debt is good debt.  In commercial terms, if the cap rate on the property is higher than the rate you're paying on the debt, that's good debt.  You're borrowing at one rate, and getting a higher rate on the investment you make with the borrowed money.

If you borrow money to buy a liability, that's bad debt.  You're buying something, like a car or a TV, and then paying not only for the liability but also the money used to buy the asset.  That $20K car costs you $30K before you pay it off.

So, any debt that's carried on something that doesn't make you money is bad debt.

Michael Shadow · Answer

Hello Aef, welcome to BiggerPockets.

Good debt puts money in your pocket and bad debt takes money out of your pocket.

-Michael

Bryan Hancock · Answer

I tend to agree with you though.  I really like having leveraged income-producing real estate as an inflation hedge and as a savings vehicle long term.  Borrowing money and having someone else pay it back for you is a good thing.

Rich Weese · Answer

"Mike, you're right, what ever debt you have, you'd be richer if you didn't have it. "

Not neccessarily.

My example, slightly farfetched, maybe. 
 I buy a 20 unit building
1. zero down owner financed
2, Break even after all expenses-no net
   So far, I have as much money as I started with and am the same richness as before.
    However, I now have the following.
1. Tax benefits to help with after tax income which saves me taxes and makes me richer.
2. Tenants paying off principal of loan which creates equity and makes me "richer"
3. Possible appreciation over extended time may also make me richer.
     Anything I missed in my scenario? Rich

Michael Rossi · Answer

ALL DEBT IS BAD DEBT!  The debtor is always slave to the creditor.  If you can be out of debt - there is nothing better.

Unfortunately, most of us can't build a business without taking on the inappropriately named "good debt", which has alread been defined above (although there is nothing good about any debt).  Quite obviously, borrowing money to buy a rental that pumps out cash flow every month is MUCH better than borrowing money to buy a new car; a motorcycle; a boat; or any other bling.  In fact, I would go so far as to say that borrowing money to buy toys is just plain stupid.  "STUPID DEBT" would be a better term for this type of debt.

While I'm talking about it, even buying something with cash can be STUPID.  Been there and done that!  For example, I once paid cash for a brand new Mercedes.  What did I get for all that cash?  A car that was only "new" until I drove off the lot - when it instantly turned into a used car.  I could have bought a rental with the money I lost the INSTANT that I drove that car off the lot!  STUPID!   Never again.  I still have nice cars and a lot of toys, but I NEVER BUY NEW when it comes to cars, motorcycles, boats, airplanes, etc.  You might as well light your money on fire!  If we're going use the terms "good debt" and "bad debt", then we should also use the terms "good cash" and "stupid cash".  Buying a like-new car for thousands less than a brand-new car - "good cash".  Losing tens of thousands of dollars just to own a "new" car as it's driven off the lot - "STUPID CASH"!

Bill Gulley · Answer

Mike, you're right, what ever debt you have, you'd be richer if you didn't have it. But in business, debt makes since because money is a limited commodity, it's the use of debt that has to be understood. I haven't had a car financed since I got out of the Army, all my toys have been paid for, but the example was not about toys, it's about living beyound your means with debt, but then how we live might place us in situations where we might gain more advantages. We are clearly a debt society and the perceptions we have about the Jones' may not be reality.

Bill Gulley · Answer

Hi, all good answers and I like Mike's referring to non-appreciting assets. To tweek that with other answers, it's "non-aerning assets" Your earning assets make a contribution to your net worth, either from cash flow or appreciation.
I'll pose this question to ponder; what about debt on depreciating assets that contribute to your ability to conduct business? According to answers so far this seems to be falling in the "bad debt" category.

We accept debt in our culture to the point of excess and most is really bad debt, but if you have a car loan, that's a depreciating asset. You use your car for personal use but probably won't sell it to dump the debt. The car contributes to your ability to earn, you won't ride a bycycle to preview propereties!

Carry this a bit further, let's say that some contractor buys a bassboat, a decent little $40,000 dollar boat and finances the boat. Most will sy that's really bad debt. But, now let's say hes in a bass tournement club with several  real estate investors. He has one of the fastest boats in the club and he asks them to go fishing with him. After several trips he picks up business and begins doing work for a couple of the investors. DId that debt contribute to his business....?

The same can be said about alot of our toys. While we may not really be able to jsutify the use of our toys in our business, not really a business asset, they may present opportunities to meet socially with other people that we eventually do business with. If the contractor picked up five deals making 60K, can the boat contribute to your business, is it bad debt at that point?

Our country, IMO more so than say europeans, are pretty snobby. We tend to judge a book by it's cover, we judge success by perception of a person. We all rather do business witha successful person rather than someone we perceive as living on the edge of financial disaster. Impressions to count, especially in marketing yourself.

So, will your socioeconomic status be viewed higher, initially, if you roll up in a Lexus rather than a Linx? Do you really think that all the gurus have their yachts paid for?

So, bad debt might be debt you can't afford. I'm not trying to give anyone ideas as how to justify to thir spouse that buying toys will help your business. Interest or debt od non-earning assets is part of the cost of that item, so the price is much higher.

I have to laugh when I see furniture stoes say, zero interest for one year! Do you really think you're not paying interest? It's in the price. Offer them cash for much less and you'll find out. No business is going to allow inventory out the door below their cost of capital!

Really bad debt is that you really can't afford to pay. Bill

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Bryan Hancock · Answer

"Bad debt" buys stuff/junk that either incurs meaningless debt service or is "wasted" from a financial independence perspective.

If you buy some income-producing property where the annual loan constant times the LTV is less than the capitalization rate you will get positive cash flow.  If you don't it will negative cash flow.

Note that most investors ignore very important items like capital reserves, vacancy, repairs, etc. when they calculate "cash flow" on single-family investments.  People think that they are getting gross rents - PITI in cash flow each month when they are really in a negative cash flow position and must have the property appreciate (or dollars depreciate with rent bumps) to make money in the long run.

Dane Whales · Answer

Michael explained it well and simple... Good debt is an asset while Bad debt is a liability...

What are differences between the good and bad debt?

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