Debt is a complex concept. If you use debt carelessly and irresponsibly, you'll get into financial trouble. On the other hand, if debt is used in a calculated and intelligent manner, it can help you build tremendous wealth. Therefore, you must be able to distinguish between good debt and bad debt if you want to be successful financially.
What is the difference between good debt and bad debt?
Generally, good debt is investment debt that helps you buy an asset that appreciates in value over time. In other words, your net worth will increase resulting from taking on that debt. Examples of good debts are taking out a home loan for an investment property that generates rental income, loan for a business start-up, or a student loan to further your education.
Bad debt is the debt you incurred to buy unnecessary things that you can't afford to pay up in full. Bad debt buys you liabilities - things that loses its value over time. Things like cars, designer clothes and gadgets loses their value the moment you owned them. The next time you buy the latest smartphone, try selling it the moment you walked out of the shop and see how much it is worth! Examples of bad debts include car loans and credit card balances (the worst type of debt since credit card companies charge the highest interest rates). Bad debt keeps you poor if you can't restrain from spending on luxuries and pay for them in a timely manner.
While it is difficult to live debt-free (most people can't pay cash for their houses, cars or children's tertiary educations), many let their debts get out of hand by spending on unnecessary luxuries they can't afford. Please don't get me wrong. I like luxuries as much as the next person. The luxuries that I enjoy are paid for by my income-generating assets built up over the years, not by taking on bad debts that I can't afford to pay. How did I do it? Well, I spent less than what I earned, invested the difference, and took on good debts to expand my base of income-producing assets. I keep investing my savings to accumulate assets until I can comfortably afford to take on debts for some luxuries of life.
The challenge for all of us is to determine which debt makes sense and which does not. Where debt makes sense, take loans only when you can afford the monthly installments. Ideally, your total payments towards all your debt obligations each month should never exceed 40% of your gross monthly income. Manage your finances wisely by incurring some good debts and reducing or eliminating bad debts.
Avoiding debt at any cost is not a smart way of managing money. Understand how to manage debt as much as to manage investment risk is the way to go to be a good financial steward. The fact is that it is near to impossible for you to work and save your way to massive wealth. Hence, if your money is not working hard for you 24/7, you'll never become really rich and financially free.
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