Good or Bad Debt? Is Your Debt Creating Income Greater than Interest

Debt is a worrying problem for everyone involved just as it was when I was having financial problems. I hate debt. I don’t like the feeling of owing anyone money. Though I was repeatedly taught in my youth to avoid debt like the plague, I didn’t listen very well — I was nearly $1m in debt at age 25!

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 Some things are learned the hard way. As much as I dislike debt now, not all debt is created equal: there is both good and bad debt. Most of us have too much bad debt. I think it is fair to say that we can all use a little refresher in what constitutes good debt vs. bad debt.

Good debt
Good debt is debt on assets that are earning income for you at a rate greater than the cost (interest) on the debt. Large corporations use something called the hurdle rate to determine if an investment is worthwhile. The hurdle rate is simply the cost of capital. If the hurdle rate is 15%, then only investments or purchases bringing in more than 15% would be considered “good debt.” If you are using a credit card for “good debt,” you better have a great return!

In addition to positive returns, good debt includes anything you truly need but cannot pay for in full without wiping out your cash reserves. From a cash flow perspective, however, you should only take loans for which you can afford the monthly payments. Purchasing equipment for your business would be a wonderful example of this kind of debt. Most equipment pays for itself with the revenue it produces, so structuring a lease or financing program with manageable monthly payments is a wise usage of good debt.

Bad debt
In contrast to good debt, bad debt does not create an income greater than the interest of the debt. Bad debt also includes debt you’ve taken on for things you don’t need and can’t afford. Most of these purchases don’t just fail to produce a greater return than the interest expense, they produce no return at all! Some even produce a negative cash flow. Most importantly, bad debt doesn’t help you grow your business.

Your financial success in business and life will largely be determined by your ability to discern between good and bad debt. I’ve interacted with many business owners who have problems with bad debt, but I’ve met a lot who shun all debt. Both types of business owners are going to have limitations to what they can do with their business. Embrace good debt. It will give you the leverage you need to take your business to the next level.