Blog | Entrepreneurship, Real Estate

What is Bad Debt? (And How To Use Good Debt Instead)

Not all debt is created equal and why you want good debt over bad debt

When I was growing up, my poor dad said, “Debt is bad.”

When I used a credit card to finance one of my first investment properties, a condo in Hawaii, my poor dad couldn’t believe it. “Why take such a risk,” he said. The investment, however, wasn’t a risk. With the rental income, I covered my expenses for the credit card payment and had some extra cash afterward each month.

My poor dad spent most of his life avoiding debt, taking it on only in emergencies. “That is what credit cards are for,” he said. He also worked hard to pay off his mortgage and saved money to buy things cash whenever possible.

My rich dad, agreed with my poor dad—to a point. “Some debt is bad,” my rich dad said. “But some debt is good too,” he added.

He encouraged me about using my credit card for an investment if it made sense. For my rich dad, everything was about context. Debt itself was neutral. How you used it, and in what circumstances, is what made it good or bad debt.

Good debt vs. bad debt

Today, many people are living by the old rules of money, the rules of the poor and the middle class. The so-called financial experts continue to preach the values of saving money, getting a good job, buying a house, and investing in a diversified portfolio of stocks, bonds, and mutual funds.

The problem with these strategy is that savers are losers because as the Fed prints record amounts of money savings lose value, especially as inflation kicks in and grows faster than the interest paid on savings. Getting a good job doesn’t provide the security that it used to, and it’s actually the riskiest thing you can rely on. A house is not an asset ; it’s a liability. And what people preach as diversification is not really diversification and is actually bad financial advice.

The problem is that among the sacred cows of financial advice is that debt is bad. That is what my poor dad believed, and it’s what millions upon millions of people in the world believe as well.

Understanding the difference between good debt and bad debt requires an understanding of assets versus liabilities. Simply put, an asset is anything that puts money in your pocket each month. A liability is something that takes money out each month.

Again, this is all about context. Take for instance a truck. If your truck is a personal vehicle, it doesn’t put money in your pocket. It takes it out of your pocket in the form of a loan payment, maintenance and repairs, taxes, and insurance. Because of this, it’s a liability. If that same truck were a used for a business as part of making money where the income would cover the cost of a vehicle, such as a construction fleet, it would be an asset because it would put money in your pocket each month.

Looking at the debt behind both scenarios, we can see the difference between good and bad debt. In this case a loan for the truck as a personal vehicle would be bad debt because it is in service to a liability. But a loan for a truck used for business and that makes you money each month becomes good debt because it allows you to obtain an asset.

The riskiness of bad debt

When my rich dad heard my poor dad’s explanation of a credit cards only good for emergencies, and his disdain for me using it for an investment that made me money each month, he simply chuckled. To my rich dad, taking on debt only in emergencies was the worst debt of all. “It’s funny to me that people think taking on debt in an emergency isn’t risky but that taking on debt for investing is,” he said.

Rich dad believed taking on debt in emergencies was a sign of poor financial intelligence. It showed that you were living paycheck to paycheck, which meant you probably didn’t have many assets and probably had many liabilities. As he educated me, it became clear that bad debt was the riskiest debt of all, but somehow most people had been fooled into thinking it was necessary debt, while all other forms of debt should be avoided.

“Follow the money,” rich dad said. “Why do you think it the financial industry wants people to only take on bad debt?”

The answer, of course, was people who were already financially in trouble and needing emergency loans, were also the same people who would not pay those loans off and continue paying interest to the debt holders for many years to come.

My rich dad and my poor dad both agreed that it was good to only buy liabilities like cars, televisions, and more with cash rather than financing them. Rich dad agreed debt was bad when used for luxury items that lost value over time. But he differed from my poor dad because he believed in using good debt to create cash for those things and more, while my poor dad believed in saving and spending, and only using debt when it was an emergency.

My poor dad would save money and then spend it. My rich dad would borrow money that made money for him to spend many times over.

Though I didn’t know it at the time, my rich dad was teaching me a fundamental lesson that the rich know about money—debt can make you richer, if it’s good debt.

The power of good debt

My simple definition of good debt is debt that puts money into your pocket rather than takes money out. For instance, if I’m using debt for a business deal, I won’t do the deal unless the cash flow from the deal pays for my debt payment and expenses while providing a good return.

This assures that cash comes into my pocket each month, providing a continual income that allows me to enjoy liabilities.

The great thing about debt is it allows me to leverage my existing cash into many assets.

For example, in real estate, I can buy investment properties with debt. The bank will give me a loan for 80 percent of the purchase price while I only have to use my money—or someone else’s—for 20 percent of the purchase price. My job is to find a deal that pays the bank the interest on the 80 percent while still providing a decent return on my 20 percent.

So, using simple math, if I have $100,000 in cash, I could buy one property for $100,000 that gives off $800 a month in cash flow—a little over 9% annual return.

Or I could use good debt to buy five $100,000 properties. The bank would lend me $80,000 for each property and I would divide my $100,000 into five $20,000 down payments. At 5% interest, the payment on the loans would be around $500. So, my cash flow on each property would be $300 a month ($800 in rent – $500 in debt payment = $300 per month) for a total of $1,500 ($300 x 5 = $1,500) per month—an 18% annual return. That is twice as much as if I’d only used my own money to invest.

I can then use the income from my properties to either invest in more assets, or I can buy something nice for myself or for Kim knowing that more cash will come next month from my investments. Rather than save and spend like my poor dad, I invest and spend like my rich dad.

That’s the power of good debt. And for that lesson, I owe my rich dad a debt of gratitude.

The rich used good debt to get richer in 2008

The difference between the rich and poor thinking on debt was on grand display during the Great Recession. While most people were fearful and saving their money, the financially intelligent, were making a lot of money and borrowing more of it. Why? Interest rates were at the lowest in history and many assets were priced at bargain bin prices.

The financially intelligent understand they could borrow money at cheap interest rates and use that money to buy assets that provided cash flow that covered their debt payment and expenses while putting money in their pocket every month.

Both individual investors and large companies grew their good debt. As The Wall Street Journal reported in 2011 in an article called, “Companies Rush to Borrow,” “Banks have lent $66.6 billion this year in five-year U.S. corporate investment-grade loans, some of the longest available, almost 25 times the amount for the same time last year, according to Dealogic. Investment-grade loans to U.S. companies have more than doubled so far this year compared to the same period in 2010. Junk-rated companies have also been able to raise debt at a record pace.”

Translation: Money was cheap so companies stocked up on it.

Similarly, my real estate advisor, Ken McElroy, and I spent a lot of time buying multi-family properties in prime markets. The easiest commercial loans to get during the time were Freddie and Fannie loans because the government wanted investors to provide affordable housing. So, we bought great properties at rock bottom prices with cheap debt. Now, over a decade later, most of those properties have sold at many times over what we paid for them. We are now actively investing that money in even bigger deals.

So, while many people were running away from debt, thinking it was bad, and others were going down financially because of bad debt (i.e., sub-prime mortgages for houses they were told were assets but were really huge liabilities), Ken and I were doubling down on good debt to get rich.