by David Kramer

Created on: December 08, 2007

There are two different kinds of debt, good debt and bad debt. Simply saying credit card or consumer debt is bad and mortgage debt is good is a dangerous over simplification. Understanding money and debt principles can help one always make a sound determination between good and bad debt.

First of all, money only has value in parting and when. Consider $1 today verses $1 ten years ago. The same dollar can purchase less today than it could then. This is because it was perceived to be worth more back then. If the dollar from ten years ago was kept all these years, it is still a dollar but the value received only comes when it is spent or used in some way. This is the time value of money principle.

The time value of money principle is mathematically model as well (F=P(1+i)^n). The future worth of money is equal to the present worth times one plus the interest rate raise to the number of compounding periods. Knowing how to do the math is not necessary as there are many time value of money calculators available free on the Internet and is a built-in formula in most spreadsheet applications.

Using this, the key to knowing when debt is good or bad is based on knowing what money costs based on interest rates and compounding periods. If a person is earning a 10% annual rate of return on investments, but can borrow money for 7%, it is better to borrow the money than to stop investing because the next gain will be 3%.

It does not matter if it is a credit card, mortgage, loan, or whatever kind of financing. As long as the cost to finance is less than the cost associated with taking money away from growing investments, then it is better to borrow. This is, if borrowing is necessary at all.

One must also consider all the costs, however, when borrowing. Certainly it is better to borrow to buy real estate than it is to buy a new television. The real estate is likely going to increase in value over time whereas the television will decrease in value. This does not really have anything to do with debt, but is really more about wise purchasing decisions.

A wise purchasing decision is to buy items that produce income or increase in value to then use the increased value to finance those nice to have items that decrease in value. This requires discipline, and often a delay in purchasing the nice to have item, but in the long run it creates a better financial standing.

Debt can crush and destroy a person financially, or it can be used and leveraged as a tool to maximize short-term and long-term needs by allowing someone to buy current the current value of money at a rate lower than what one can sell their money for to someone else. When the cost of borrowing is less than what you can earn on your money being used elsewhere, you have the opportunity for good debt when debt is necessary.

Learn more about this author, David Kramer.
Click here to send this author comments or questions.