This article is part of the money myths series. We explore one money myth at a time. We look at how this money myth may be keeping you from more money. This time, we will be exploring the money myth that all debt is bad.

Introduction

This is another common money myth most people believe in, that all debt is bad. There is good debt and there is bad debt. We’ll talk a little bit about each and what’s the best thing to do.

Bad Debt

Let’s start with examples of bad debt:

• The high APR that comes with credit cards.
• Using a credit card offered by a vendor to buy something, say clothes or electronics. You do this because you normally cannot afford it. Miss one payment and you are charged all interest from day one, when the loan started.
• Car loans
• Taking a loan against your 401(k)

Of course, some of the items in the above list aren’t necessarily bad if done correctly. For example, you may really need to borrow against your 401(k) because of some medical emergency. Or you need to finance a business or take a class. Then borrowing against your 401(k) is a good idea, especially if you cannot get the money any other way.

Now, if you take out a car loan, just be sure you follow the 20-4-10 Rule. This nifty rule makes sure you’re not over-extending yourself when it comes to buying shiny new cars. With the 20-4-10 Rule, you put down 20% and take a 4-year loan on the remaining balance. After this, your monthly payments, including insurance, should not exceed 10% of your monthly gross income.

Of course, I buy used cars because the deprecation on a new car is just atrocious. The deprecation in the first year of owning a new car is the greatest. Years 2, 3, and 4 typically equal the depreciation experienced in the first year of ownership. So, if you don’t mind owning a car that’s 4 years or older, then that puts you in better financial shape.

As for buying an item from a company that offers financing with their credit cards, be careful with this one. While they let you break out the monthly payments over a span of several years, the APR is often high (over 20%). If you miss just one payment at month 23 of a 24-month loan, then you end up pay interest for those 23 months! My rule of thumb is if you can ensure you will not miss a payment, then this is a good way to reduce your financial burden because you’ll avoid paying a big balance right off the bat. Of course, you do this because you have better uses for the money, like investments. This is just using debt as a tool to buy time.

Good Debt

Just like there is “bad” debt, there is also good debt.

• Mortgage
• Educational loan
• Skills-building loan
• Investments (business, real estate, or stocks)

For example, a mortgage lets you write off a huge part of your taxes so as to reduce your overall tax liability. 

As for taking a loan out for education and skills-building, I say go for it! Anything that helps you build skills and makes you more marketable is also worthwhile getting into debt for. The reason is simple: You hopefully will get a nice return on your investment, usually by making more money.

It’s Simple, Really!

So, not all debt is bad! Debt is just another tool. It enables you to own things which would have otherwise been outside your reach. After all, how many people are able to pay for a new car or a new house in its entirety?

The best way to determine if the debt you’re about to incur is bad is by asking yourself if you will see a return on your investment. The return may be something as concrete as making more money to offset and pay off the debt.

Would it be better to pay off a car loan as soon as you can or just follow the scheduled payments? You incur an opportunity loss when you pay off your debts. The money that would have otherwise gone to investing has now gone to your debtors.

For example, the interest paid on your loan 5-year is $1500. That may sound like a lot. So, you double down and pay off the car loan in half the time, cutting the interest payment by roughly half ($700).  But in paying off the car loan, you gave up on the opportunity of investing that money. If doing the math shows you’re better off paying yourself first through investing, then by all means incur this debt!

Or it may be something less straight-forward, like a family trip. Of course, having a lifetime of memories and experiences to reflect on and build an emotional bond with your family is worthwhile too.

In the end, you really don’t need to be buying a $5 cup of coffee from Starbucks, take on more car loan than you can handle, or buy more house than you can manage. Money management is really about living within your means, finding ways to save, and turning the whole thing into a game. Because when you turn making, saving, and investing money into a game it’s much more interesting and less scary.

If you enjoyed this article, then I invite you to get your free copy of 7 Money Myths Preventing You From a Positive Cashflow.