Good debt, bad debt
Borrowing can lead to wealth or financial oblivion.
Debt is the great divide between financial success and financial failure. When you look back at a family’s financial life over years, you see that there are some borrowings that have represented step changes towards either financial success or financial disaster.
The things for which people borrow and the way that they manage debt is so often the difference between spectacular wealth and permanent poverty.
There are three kinds of debt: the first, good debt, is used to buy good property or businesses – things that grow in value and/or will give income. This includes debt for education which can be good debt if the education provides additional income.
The families that take on good debt find themselves in a land of plenty: they reduce debt as they make repayments and grow income and/or asset values.
This gives a virtuous cycle. The debt reduces but the income and the assets grow. This allows for more debt to be safely assumed, leading to greater asset values and more income. Just about everyone I know who has become wealthy has used debt in this way to accelerate wealth accumulation.
The second kind is bad debt. This is debt used to buy value losers, things like cars and kitchen appliances. Borrowing for these things leaves you in a position of slowly reducing debt but sharply reducing asset values. Chances are that car just bought on hire purchase is worth $2000 less before you even get it home.
Not only does this debt come at a much higher interest rate, but also has a kind of addictive quality. Once borrowers realise how easy it is to take home some shiny new things with a simple signature, there is nothing to stop them doing it again. And again.
These families are caught on a treadmill as they pedal ever faster without going anywhere. Financial life becomes a hard uphill grind.
Finally, is the third kind of debt: debt that is just plain ugly. Ugly debt is used for consumption – like holidays, clothes or groceries. Often loaded on to a credit card with little prospect of rapid repayment this debt frequently triggers the start of a vicious cycle – a kind of financial death spiral as the family borrows and then has to borrow again to make the repayments. Typically, these people do not just struggle, they go backwards to financial oblivion.
Yes, you may deserve a winter break in Fiji, but if you put it on a credit card with no plan for repayment you will pay a huge price for seven days on the beach.
Getting out of bad or ugly debt is difficult. Like substance abuse and addiction, the easiest thing is to never start.