4 Ways To Distinguish Good Debt From Bad Debt

The average interest rate on a bank credit card is currently 21.5%, which is the highest since the Fed started tracking the data in 1994.

Do you have credit card debt?

If so, do you know what interest rate you’re paying?

Not all is debt is created equal. Some forms of debt can actually help you build wealth if used strategically. But how can you tell "good" debt from "bad" debt?

Here are four key ways to make the distinction:

#1: Good debt puts money into your pocket.

The key to evaluating whether debt is good or bad is how it impacts cash flow.

Many people wonder if their residence is an asset or liability? Generally speaking, your home is a liability because it costs you money to live there.

It takes money out of your pocket.

According to Rich Dad Poor Dad author, Robert Kiyosaki, “Bad debt is debt that makes you poorer. I count the mortgage on my home as bad debt, because I’m the one paying on it. Other forms of bad debt are car payments, credit card balances, or other consumer loans.”

Good debt, on the other hand, is when you are able to invest borrowed money and earn a higher return than the cost of borrowing.

For instance, if your mortgage has a lower interest rate than you’re able to earn on your stock portfolio, you may be able to pocket the difference.

Student loans for lucrative careers like medicine can also qualify as good debt. Taking on short-term debt can greatly improve a borrower’s future earning power.

#2: Bad debt takes money out of your pocket.

One way to categorize debt is by differentiating between installment debt and revolving debt.

• Installment debt is the kind you pay over a set period of time, like a student loan or a mortgage.

• Revolving debt is the kind with no end date—e.g., a credit card.

Tip: revolving debt is usually bad!

Credit cards take money out of your pocket in interest and fees. And credit card interest rates tend to be egregiously high.

Car loans also strain your balance sheet, because cars depreciate quickly.

As a general rule of thumb, try to avoid using debt to buy stuff that won't earn money or appreciate.

#3: Good debt builds equity and assets.

There is an accounting relationship that everyone who wants to achieve financial freedom must understand: Assets - Liabilities = Equity .

Equity makes you richer. That’s what increases your net worth.

As a general rule, I try to own appreciating assets and rent depreciating assets.

For example, cars depreciate quickly. So, if you’re someone who likes to get a new car every few years, I think it’s usually better to lease a vehicle.

Bridge loans are a potential example of good debt.

For instance, I have a retired client who wanted to buy a new home, and she was presented with two options.

1. Take out a bridge loan to buy the new house, knowing that her old house—once sold—would generate enough proceeds to pay off the new loan in full; or,

2. Sell investments to pay for the new house.

My client chose the first option, because the loan helped her avoid transaction costs, taxes, and the opportunity cost of selling investments.

#4: Bad debt erodes net worth.

High-interest credit card balances and lines of credit impede wealth building by draining cash flow.

Reverse mortgages are frequently marketed to retirees, but they have drawbacks. Withdrawing equity via a reverse mortgage actually means taking out a loan and pledging your home equity as collateral. That gives the lender a stake in your home, or if you pass away, a potential stake in your heirs’ assets.

Most retirees should try to avoid taking on interest-bearing debt, because debt increases the level of risk on their balance sheet.

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The bottom line? Good debt strategically employs leverage to invest profitably and grow assets. Bad debt can become an albatross, weighing down your personal balance sheet. Distinguish wisely between the two based on their cash flow and equity effects. Debt isn't universally good or bad - it depends on how skillfully it’s used.

By Michael Cannivet, Contributor