When I was a kid I was told to avoid sugar at all costs, attempts from my parents to keep me from bouncing off the walls. As I grew older, I was told that we need sugar to survive and that processed sugar should be avoided. This year I trained for and completed my first Century, 100 miles on a bicycle. In my training, I learned that many endurance athletes specifically use processed sugar and other types of ingredients to achieve continued performance using the extra energy in exact and controlled ways without the negative side effects.
It’s the same story with debt. At the beginning of your personal finance journey, almost all advice out there says to avoid and get out of debt at all costs. There are extensive programs, courses, podcasts, and companies based on getting people out of debt.
This isn’t wrong but it’s a simple idea, and if we dive deeper and understand a little bit more we will find that we can actually use debt in incredibly helpful ways and determine when it is good debt vs bad debt.
Trading time for money
At the beginning of most people’s careers (and often throughout many people’s lives) they are exchanging their time and training for money. This is everyone who receives a W2 or 1099. If you are employed to do a job, and you only get paid if you’ve done that job, this is known as active income by the IRS, as opposed to passive income.
For many, this will be their whole lives. The objective of most personal finance books is to take us to the next level, to slowly stop exchanging time for money and instead earn money from our assets.
Assets can be a lot of things, this can be your house rented as an AirBnB, stocks or bonds, index funds, royalties, or interest payments. Robert Kiyosaki, the author of Rich Dad, Poor Dad, says an asset is anything that earns you money. This is what we want.
Earning money from assets
Assets usually have a cost associated with them. For instance, if you bought a house for $500,000, and then rented it out for $50,000 a year, it would be earning you 10% per year of your purchase price. Most people’s paths are they trade their time for money until they can afford the $500,000 (whether that’s through a mortgage or not), and then start earning income based on that asset. This is passive income, while you might do some work or have some expenses such as a property manager or house insurance, for the most part, you’re not doing much actively to earn this money.
Similarly, if you put your money in an index fund in the stock market and it goes up by 10% in a year, you’ve now gained a lot of money that you didn’t do any active work for.
If you were earning $100,000 per year, and now you earned an additional $50,000 per year, that means your total income is $150,00, and 1/3 of it is passive income. This is great. We want to keep doing this until our assets can pay for the lives we want to live, then we are financially free.
But we’ve veered away from debt. In the examples above, we talked about getting 10% a year. This is a positive 10% increase. Debt always has an interest rate and it’s a negative percentage.
Bad debt: the path to failure
If you got a loan (debt) for $500,000 that required interest payments of 15% a year, but you only earned 10% a year on that $500,000, then you have negative 5%. Let’s look at some numbers:
$500,000 * 15% = $75,000 (your interest payments)
$500,000 * 10% = $50,000 (your passive income)
$75,000 - $50,000 = -$25,000 (your net income)We can calculate this result in another way:
[Expected Return Rate] - [Debt Interest Rate] = Your True Return
15% - 10% = -5%
$500,000 * -5% = -$25,000That -5% is a really important number. This is bad debt. This debt costs you money. This debt has to be paid by trading your time for money. We want the opposite, we want to be able to trade assets for money. We want the rate of return with all debts and expenses to be a positive number, and the bigger the number the better.
Good debt: the path to financial freedom
Let’s look at what happens if we flip those numbers we gave in the previous example. Let’s say we acquired $500,000 with 10% interest payments, but we earned 15% on that property. It’s not hard to see that we now gained $25,000!
In real estate, these are called zero-down deals, because no money of his own was put down. He used other people’s money (OTM). I’m going to write many more articles about OTM because it is by far the fastest (but not necessarily easiest) way to earn wealth. Debt, by definition, is OTM.
Good debt is determined by whether you receive a higher rate of return than your interest payments.
Bad debt is when you get a lower rate of return than your interest payments.
Let’s look at a few examples to drive this home.
Good debt vs bad debt examples
Example 1: Your credit card has a 22% APR (your interest rate on debt), but you have a contract for selling someone goods that will net you 100% return. This is an excellent use of good debt because it is +78%.
Example 2: You have a family friend who is willing to give you a loan at 2%! But you don’t have anywhere to invest it and your savings account is only getting you 0.5%. If you took this loan, this is bad debt because the rate of return is -1.5%.
Example 3: You have a friend who is looking for an investor and can offer than 10% interest rate on $100,000. You don’t have that money, but you have a friend willing to loan you the money at a 9% interest rate. Despite it only being +1%, this is a good debt and you still get a completely free $1,000 out of the deal.
Take action now: calculate your current debts
Now that you understand how to evaluate debt opportunities, here’s your action plan:
- List all your current debts and calculate their true return using our formula
- Look for opportunities to refinance any negative-return debt
- Start researching investment opportunities in your area that consistently generate returns above typical debt interest rates
Remember: The goal isn’t to avoid debt—it’s to use it strategically. The most successful investors don’t ask “Should I use debt?” They ask “How can I use debt to accelerate my wealth building?”
The simplicity on the other side of complexity
“For the simplicity on this side of complexity, I wouldn’t give you a fig. But for the simplicity on the other side of complexity, for that I would give you anything I have.”
― Oliver Wendell Holmes
This is one of my favorite quotes, although without context it can seem meaningless. The “simplicity on this side of complexity” is similar to saying “debt is bad” while saying the “simplicity on the other side of complexity” is understanding that debt can be good or bad, but as long as it had a positive rate of return, then it can be good.
I hope this gives you more of a basis to form your own opinion next time someone tells you to never use debt or to get out of debt at all costs. At the same time, you can probably understand that high interest rates such as credit card debts are most likely going to be bad because it’s hard to get an income rate higher than the debt rate.
