What is the difference Between Good Debt and Bad debt?

What is good debt and what is bad debt? Well, to many people any sort of debt is bad, and to some degree they are perhaps right. However, anyone who is wealthy, especially if they got that way through their own entrepreneurial skills, will have a slightly different understanding of debt.

Debt is a necessary thing to have if you want to accumulate serious wealth. Most people, if you explain it to them, will understand the concept. After all, the thing that most people own which is making them the most money is their house.

The truth is your house, especially when you first buy it, is just one big debt. But it’s a debt that, if you are able to keep up the repayments on it, can set you up for a more comfortable retirement than if you didn’t have it. And it can be a nice little nest egg for your kids in the future as well. If you didn’t see the need to take on the debt of a mortgage on your own home, then you will probably unfortunately end up like so many retired people, living off a measly state pension and huddling in front of a fire to keep warm in the winter.

Would you class your home as good debt? Well, countless people might, but the reality is, it isn’t. Good debt is normally only found when you have invested in an asset. What is an asset, you say? Well, there are several definitions depending on who you speak to, but I think the following sentence epitomises it well: it is something that appreciates in value and/or can provide you with passive income, that pays for itself, and doesn’t need you constantly putting money into it.

So, what is good debt?

Good debt is debt that you have incurred by purchasing an asset that appreciates in value and/or can provide you with passive income that pays for itself, and doesn’t need you constantly putting money into it.

In this vein, your house could not be classed as an asset, because you live there and you have to pay the mortgage yourself through other means i.e. through working at your job for a wage to pay the mortgage or through the money you get from other assets.

This is an area of much debate as historically property increases in value so many people would still class their home as an asset, and if it helps you sleep better at night, then that's fair enough. Maybe we can class our homes as an asset - maybe a dormant one, that's ready to awaken whenever we choose to sell our house or release money from it.

And even if you have paid off the mortgage, you would still have things to pay on the house, such as utility bills, council tax, repairs etc. So you will always need to have some income from some other means in order to finance the upkeep on your home.

So, what is bad debt?

Bad debt is the opposite of good debt. Bad debt is debt that you have incurred by purchasing things that either depreciate in value and/or drain money from you.

For example, a new car, holiday, speedboat or even a rental property where the rent doesn’t cover the mortgage, and you are constantly topping up the payments with your own money.

Contrast that with a true asset like a property you own which is rented out to tenants, which gives you good passive income and potentially appreciates greatly in value over time. This sort of asset can be classed as good debt. Everything will be covered by the rent the tenant pays. For example: the rent covers the mortgage and tenants pay the utility bills themselves.

Any insurance or management fees you have to pay would have already been factored in. The only things left are repairs, the cost of which, if your rental cover is good and the property is sound, shouldn’t be too high. And when on the odd occasion something big needs changing that isn’t covered under your insurance, you could potentially just remortgage to take out that little bit of extra money.

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