Good and Bad Debt – Why We Need to Know About Them

Right now debt is a four letter word in America. With the advent of the recession, Americans cannot bring themselves to believe again that owing money could ever be a good thing. But the fact is, good debt is what made this country great. In our attempt to lower the debt ceiling (how much we can owe) and the deficit (gap between what we can pay and what we actually owe), we may very well be throwing out the baby with the bathwater.

Personal debt has become an enormous problem in this country too. Recently I was inspired by a video by Robert and Kim Kiyosaki about how they got out of debt. So, a look at how to get out of debt for individuals was my original intent in blogging today. But I found that before I could get to that topic or to the issue of our national debt, some clarifications are necessary and unavoidable. Before we can even start to “get out of debt” we have to first understand what debt actually is.

Dictionary definitions of debt refer to anything owed. Anything owed by one person to another is called debt. But financial definitions of debt are different. Debt in the financial sense is usually is limited to contractual debt. This is borrowing money on which you usually have to pay back the principle with interest. There often is confusion because people switch back and forth between these two meanings of the word, “debt.”

One kind of debt we think of most often as “bad” debt are incidental expenses, frivolous things which we didn’t really need to buy. We may owe money for these things, but they are not what is meant by Robert and Kim Kiyosaki when they talk about “bad” and “good” debt. Financial debt generally pertains to serious debt, debt which is intended to bring in income.

Another thing we think about in terms of debt is really lack of revenue. We don’t make enough money, so we are in debt. This isn’t “bad” debt either, it is just plain old debt. If debt that you can’t pay were bad debt, then there would never be such a thing as “good” debt. How could there be good debt? Ever? If debt had to be payable to be “good,” there wouldn’t be any good debt or for that matter, any debt at all! You’d just pay your debts.

It may feel bad to be unable to pay a debt you owe, but the debt itself isn’t bad or good. Yet, there ARE things called good and bad debt! You’ll find them in Robert Kiyosaki’s world, the world of his “Rich Dad“. And it’s really important to understand what the thing called good debt is if (1) you want to get out of personal debt, and/or (2) you are concerned about how we’re going to solve our national debt problem.

Assets and liabilities that underlie both good and bad debt

Good and bad debt come from owning or controlling assets and liabilities that bring you positive or negative income. Good debt is money owed on things that bring you positive income (profits). Bad debt is money owed on things that give you negative income (losses)

Assets which you are paying to own or control include things like rental property, stocks and bonds; businesses; franchises; intellectual property (such as copyrights and patents); whole life insurance policies; and leases.

Liabilities related to income-producing assets include things like mortgages, bank loans, stocks and bonds bought “on account”; IOUs or any kind of investments based on debt instruments; and debt maintenance costs (i.e., interest owed on borrowed money).

Assets you are still paying on

If you are granted legal control of assets that you are still paying off, the assets involve liabilities for which you owe money. For example, let’s say you owe mortgage on a house you rent to others. The mortgage is a liability. Because you have control over a rental house, the house is an asset. You can make a regular income from it.

When you make a regular income from a rental property that you are paying the mortgage on, you have “good debt.” But if you are losing money from rental property that you are paying on, your good debt just turned into bad debt. You have bad debt when you are losing money on unpaid assets that you still owe money on.

You also have bad debt if you have control over a house that you live in while you pay the bank for it. As is the case with a loser rental property, your mortgage is simply taking money out of your pocket each month. You are losing money on your home. Your mortgage is a liability. The money you owe on your mortgage is simply ”bad debt”.

Assets you have paid off

If you bought the rental house outright, you own an asset rather than control the asset. You do not have bad debt because you do not have debt. Period!

But if you can’t cover the expenses of owning and renting your rental house, then you have an asset that becomes a bigger liability. its expenses are taking money out of your pocket. Your asset is then going to cause you to have bad debt (perhaps on your credit card). Your paid-up asset is supposed to bring you income and it doesn’t. The same goes for a business that runs in the red. So, paid-off assets can still bring you bad debt from paying their expenses.

If you’ve paid off the mortgage on the house you live in, your house is no longer a liability; nor do you owe bad debt your house, But neither do you receive income from your house. In fact you will still owe expenses for it, such as utilities and taxes. Your house does not provide you with any money to pay off its expenses. For this reason, in Kiyosaki’s system, only rental property or property used for a business can be defined as an asset that can have both “good” or “bad” debt attached to it.

A personal mortgage is simply a liability, and it’s a bad debt until it is paid off. After that, your house has expenses that can put you into bad debt, if you don’t have enough cash-flow to cover them. (But as we’ll see later, bad debt doesn’t mean you have to pay it off to be successful. What counts isn’t the amount of your bad debt; it is the amount of your cash-flow i.e., your residual income after your expenses are paid.. Cashflow, or “residual income,” comes from paid-off assets and good debt.)

Asset- and liability- windfalls through arbitrage (buying and selling)

What happens when assets are paid for fully? They are not debts any longer. They are simply assets. If assets don’t produce any income, they are either potential assets, e.g., land or a house you might sell for a profit in the future, or they are just plain old things which may or may not cost you money (i.e., expenses) to keep and enjoy. And here we come to the need to sort assets into two kinds.

One kind of asset produces money “periodically” or at intervals; the other kind of asset provides only a one-time payment. For example, your house can only be sold once. That is when you will make or lose money on it. This kind of one-time income from buying low and selling high is called arbitrage. Arbitrage is the difference between the buying and selling prices (usually within a short period of time). Arbitrage is the reason a house you live in is sometimes called an asset. You can make (or lose!) money on your house, but this only happens once – when you sell it.

Through arbitrage, you have one-time income (or loss) from a liability and/or an asset. For example, if you borrow money to “flip” a house, you are in debt for your liability (the mortgage), but you intend to make money from the house (your asset) when you sell it. You don’t own the house; the bank owns it, but you control it, and you have the right to fix it up and sell it to another buyer. You can make a one-time income from this kind of arbitrage on a debt you sell.

You can make or lose money when you sell previously-paid-for assets like stocks or bonds too. The same thing goes for stock you buy with money your borrow from your broker. This stock is a liability that you can sell for a profit on a one-time basis, But these kinds of assets and liabilities are not called “good” debt in Kiyosaki’s system either. They are more like windfalls. Windfalls (in the form of capital gains or losses) are important in terms of making money, but you can’t count on them. They can’t be included in your good and bad debt calculations because windfalls are not regular income coming in a periodic intervals.

The importance of understanding good and bad debt

Why is it important to know about good and bad debt? Because the object of the “game” in Kiyosaki’s world is for you to make enough income from “good debt” to get out of the “rat race” of working at a job or in self-employment. Good debt, like outright ownership of an asset that pays a steady income, is a good thing!

Bad debt, however, is not intrinsically bad. A thing which is a liability, e.g., a car, can be turned into an asset by simply adorning it with advertising for a business. A yard can be used to grow produce for sale. This kind of use brings in money. A thing which is a “non-productive” asset over the long-term can still be sold for a one-time windfall. A thing that is a liability can also be useful as a way to lower necessary personal or business operating expenses.

For example, if a home mortgage is cheaper than a rental, a mortgage may be your best choice. When it comes to getting out of the rat race, sometimes you need to lower your necessary expenses (including paying down bad debt) in order to get out: but other times it doesn’t matter if you have bad debt as long as you are taking the right steps to increase your good debt and create cash-flow; your cashflow will get you out of the race.

This is a way of thinking that is utterly foreign to most Americans. If you don’t “get it”, don’t worry, I’ll be writing about it further, and you can also read the Rich Dad Poor Dad series, play the cash-flow games, or listen to the Kiyosaki videos and audios online. Or write a comment in the box below!

Related terms: assets and liabilities