What Good Debt Really Is

When people hear the word ‘debt’, it’s often thought of as a negative thing. The idea of borrowing money from someone or from any lending institution has been associated with stress and financial burden. But debts are more than just the money we borrow to pay for bills, emergencies, or other things we need or want.

While paying back what we owe is an obligation, not all debts are considered bad. In investing and business, one of the eye-opening concepts people learn is the difference between a good debt and a bad debt. And good debt is not just borrowed money used to earn income. There’s more to it than that.

So in this article, I’ll be sharing with you 2 simple ideas that I hope will serve as a reminder for you about what good debt really is and to help you with your financial decisions.

Now, let’s start with the first.

Good debt is sometimes used as a selling point.

Most of the time, the idea of a good debt is discussed when business and investment opportunities are involved and significant capital is needed. This is because if they want to convince you to grab that opportunity, it has to come off as a wise move. They present the idea that leveraging money that’s not yours and using it to generate income is a win-win situation.

But that’s not always the case. We have to understand that just because it’s pitched as a debt that will make you earn money, that doesn’t mean it’s already good. Caution is needed with this since there are people who disguise an actual bad debt and make it look like a good one instead.

In order to identify if a loan is a good debt, here’s our next idea.

Good debt is about the net profit.

When you search online for the meaning of what a good debt really is, what you’ll notice is that it’s all about helping you with your finances, generating your income, and even increasing your net worth. While this sounds good and is what people usually believe in, there’s actually a more correct and simpler definition. And that is: good debt is about the net profit.

There are 3 points to consider under this idea.

1. It should have a direct impact on your finances.  

   Let’s say a sales agent is planning to buy a car to travel faster and meet more clients. Is it okay to borrow money for it? The answer here will depend on her personal knowledge and skills. If she already has a proven method of finding prospects and closing deals, then this can be a great investment for her. If purchasing the car would translate to more commissions and profits for her, then this can be considered a good debt.

   But if the sales agent still lacks the skills to find clients or close deals, then this might just be a bad debt that may cause stress to her due to the monthly payments for the said car.

2. It is not about income. 

   Income is defined as the money you received in exchange for the services you offered or for the products you’ve sold. Meanwhile, net profit is what remains from your income when you've paid all of your expenses. It's essential to differentiate this so we can identify if your loan is a good debt or not.

   To give an example, an ecommerce entrepreneur is planning to borrow money to fund his business and produce more products. If, after selling the products he has and deducting expenses like the cost of goods, taxes, and other fees from the income, he gets a net profit, then it's a good debt.

3. Your net worth will follow. 

   Net worth is assets minus liabilities. It's the money you own subtracted by the money you owe. And good debt will help increase your net worth. But it's actually not a factor that needs to be considered. You only have to focus on your net profits, because when it increases, so will your net worth. But when your net worth increases, it might not be the same with your net profits.

   To understand this further, let's say you bought a condo unit for rent and your rental income is not enough to cover the monthly amortization, dues, maintenance, etc. This means you're not earning any net profit. But since you're paying for your loan on the condo, then the liabilities or money you owe are going down while the value of your condo can go up, which signifies that your net worth is increasing as well. An additional property might be good on paper, but it's still bad debt without the net profit.

Net profit is very important in this discussion, as it means you have more cash flow and more capacity to increase your income, whether used for investments or other opportunities. So borrowing money that will yield net profits can be considered good debt.

On the other hand, bad debt is something that can pull you down if not handled properly. And that's something we wouldn't want. While it's possible that you're already in a situation where you borrowed money and it turns out to be a bad debt, do remember that it's okay and you'll get out of this. As our first idea states, the concept of good debt is sometimes used to make people believe that it's a good investment when it's actually not. But now that you've read these ideas, you can make better judgments and financial decisions in the future. And I know you'll be on your way to leveraging money and making it work for you!