Borrowing & Debt
Debt is a way to use someone else's money (capital) to buy something now, and pay for it later. It’s a way of investing in your future by selling your future assets (e.g. wages) in exchange for present assets (e.g. a house). It is a way to access capital.
Debt is a great way to invest in assets that are needed to generate income (e.g. a vehicle, a computer) or assets that will increase in value over time (e.g, real estate). However, debt becomes a poor financial strategy when we have a short-term need for a non-essential asset and we use debt to purchase it. This is what we call ‘living beyond our means.’ It’s a way of spending today to live well today, but it can leave us with a lot of debt to pay off in the future.
Debt as a Tool
Used well, debt can help us purchase assets that will help us prosper in the long-term. Used poorly, debt can leave us struggling in the short-term, and facing challenges in the long-term. Debt can be good or bad, depending on the context. The trick is to know when to use debt and when to avoid it.
A good debt is an asset that will increase in value over time and will be used to generate income. A good debt is a purchase that we can afford to pay back and will be used to help us become wealthier in the long-term.
Here are some examples of good debt:
- A mortgage on a house you plan to live in, or invest in.
- A student loan for a college or university education.
- A loan for a vehicle, computer or other asset that will be used to generate income.
A bad debt is a non-essential spending decision that we cannot afford to pay back in the short term. A bad debt is a purchase that will not increase in value over time, and that we cannot use to generate income. A bad debt is a purchase that is not worth the money (interest) we pay for it.
Here are some examples of bad debt:
- Credit card debt.
- An expensive vacation.
- Any loan that is not helping you generate income.
Interest is the extra money you pay to use someone else’s money. It is a fee that is charged for borrowing, so when you borrow $100 for example, you are obliged to pay back $110, or $120, or more, depending on the interest rate and how long it takes you to repay the amount you borrowed (the principal).
The interest rate is the cost of interest expressed as a percentage of the amount that is borrowed. For example, if you borrow $100 and pay back $106, you are paying 6% interest. Interest rates can vary from 1% to 20% or even higher, so you can see that a low interest rate and fast repayment is to your advantage.
Check out our mortgage calculator for an example of how interest rates can affect what you pay on a loan.