Most of us begin incurring debt as soon as we are 18. Whether it is for student loans or credit cards or car loans, we tend to sign on the bottom line with alacrity. From that point on, the debt we hold can be categorized in one of two categories – it is either good debt, or it is bad debt.
Being debt-free is a great idea, but business and life tend to be leveraged in our economy. From home mortgages to business equipment financing, it sometimes makes sense for cash flow or tax purposes to finance a purchase.
Suffice it to say that the more bad debt we incur, the less favorable it is for our financial situation or credit standing with lenders. Business owners who rely on financing for capital needs must be especially careful when incurring debt, as the sums can be substantial and they must make sure they have the available cash flow to service the loans.
Each situation needs to be analyzed on its individual merits, but here are five quick ways to think about differentiating good debt from bad debt.
1. Good Debt Can Make Money
When used as leverage, debt can provide the capital needed for an investment that can produce a return greater than the cost of the debt. For business owners, their best investment is usually their business and they are in the best position to know what kind of return can be produced with an investment of capital.
2. Good Debt Buys Appreciating Assets
Using debt as leverage to buy an asset that will appreciate, such as a home, is considered a good use of debt. Most real estate transactions hinge on this principle of using leverage. But recent experience painfully highlights that even good debt can turn to bad debt should the underlying asset underperform or depreciate in value, so don’t assume that all assets appreciate.
3. Good Debt Pays for Investments in the Future
When an expenditure is essential to achieve a desired end and the capital is not available, a debt can be good if the family or business will be better off as a result. One example is borrowing money to pay for college expenses, provided you believe that the costs incurred will allow you to earn a sufficient income to take on the liability. Or if you are paying for training that will enhance your marketability or ability to provide a new service. Determining what the “return” on this investment will be can be somewhat subjective, so proceed with caution in this category.
4. Bad Debt Buys Consumable Products
When a credit card is used to cover ongoing business or personal expenses, the debt is being applied to products that will be consumed and, ultimately, lose all of their value. Most consumer products are depreciating assets, which means that the value of the asset could actually be worth less than the amount of the loan before the debt is repaid.
5. Bad Debt Buys Things You Can’t Afford
Purchases made with a credit card are often unaffordable, which is why a credit card was used in the first place. And when you add the interest charges to the purchase, it’s even more unaffordable. Before using credit to make a purchase, make sure it is an essential purchase and that you know when you’ll be able to pay it off to minimize your interest expense.
Being Careful with Business Credit
Business owners must take special care not to incur a lot of bad debt, especially in the name of the business. Small business owners often finance their startups on credit cards or personal lines of credit because of a shortage of cash. This is sometimes the only option, but it should be used cautiously.
And when lenders considering a business loan request, they usually require a personal guarantee which is only as good as the credit worthiness of the business owner. So take care of your personal credit worthiness as well as your business credit – they impact each other in many practical ways.