Managing Good vs. Bad Debt

“Debt, an ingenious substitute for the chain and whip of the slave driver.” Ambrose Bierce, 1860’s

“Good Debt is a powerful too, but bad debt can kill you.” Robert Kiosaki, Rich Dad, Poor Dad

Personal finance in the US typically starts with a discussion and consideration of debt. But this article is not all about how “bad” debt is. Used strategically, debt can be a powerful wealth building tool. Most of us need debt to get launched in society. We ironically start our wealth building journey in debt. We require the use of debt and borrow money to gain knowledge in a trade or in school. We can leverage debt to purchase wealth enhancing assets like real estate. But we all know there is a dark side to debt in the modern world. We live in a got to have it now culture. vacations, cars, clothes, remodels, etc. go on credit cards and more! This is not to say that all debt is “bad”. Most of us need to use debt or leverage to buy real estate and fund college degrees, things that can be assets over long periods of time.

Managing Good vs. Bad Debt

There are really two kinds of debt generally speaking. “Good debt” that helps us build wealth over time and “bad debt” that destroys wealth. The average American has $47,000 in school loan debt, $28,000 in auto loans and almost $7,000 in credit card debt. The ideal of course is to minimize debt in general. Servicing debt monthly funnels money away from saving, investing and purchasing other assets. And the interest paid on debt is the opposite of the compounding returns that can be gained on investments. That is $82,000 in the hole working against a person’s ability to build wealth. The school loan debt may be required in order to obtain higher quality employment. At a 10% interest rate for all this debt, it might cost a person another $8,200/year to service the debt. You can see how this can quickly become a debt spiral which rhymes with death spiral.

Good debt?

I have worked in real estate investing for many years. If you work in real estate you know that debt can be used as a powerful wealth building tool. When I started investing, I did not have $300k laying around to invest in real estate. I needed the leverage provided by a bank. Therefore I went and obtained a low interest loan to fund the purchase of rental property. Good debt is commonly referred to as leverage. You see, in the world of physics leverage helps us become stronger with less up front power. When we use debt as leverage, as is the case in real estate sometimes, we are using small amounts of up front capital in order to gain more capital in the future with the same asset. Even so called “good debt” needs to be managed properly so it does not become toxic debt. One example is school loan debt that has become astronomical in the US. An investment in an education can be a powerful life changing step, but the debt levels and ability to service the debt must be taking into consideration.

Bad debt

So in general, we all strive to be debt free on the path to financial independence. Debt is a kind of slavery or indentured servitude. Most of us at some point will need to take on some debt to address some pressing need. But there are several things that are not pressing needs: Fancy clothes, that tropical vacation, the expensive dinner out, the concert tickets, the kitchen remodel, the high end new luxury car. The person buying these things should be able to pay for them. Otherwise they are best avoided. When these things are put on credit cards and not paid off, this leads to a toxic debt cycle. It is like the Borg from Star Trek or being sucked into a vortex, it is very hard to climb out. It is wise to avoid debt for these things completely and only do them when you can actually afford it. The reality is that your life is complete as it is in many ways. We tend to think we need all these nice to have luxuries, but these luxuries end up costing us a lot of life energy and time.

What Amounts?

What is the proper amount of debt? This is an individual decision that has to do with risk tolerance and management. For some, the goal is zero debt. But keep in mind this can effect ones ability to build wealth, most ironically. Most Americans major asset is their primary house, which can rarely be acquired without the use of a debt instrument such as a mortgage.

Rules of Thumb

There are certain rules of thumb for how much to spend on major items based on someone’s salary. Here is an example for housing.


Ah yes, housing. You know, if we all had housing addressed (a paid off house) then we really wouldn’t need to make that much. But land and structures are expensive things. And, modern life certainly beats living in stick huts. Life can get pretty brutal by living among the elements. Therefore, we need to purchase housing. If you are just starting out in your career and are young, it’s best to find the cheapest accommodations you can find. If this means room mates, do it! Perhaps you can squeeze into a small space. I rented the smallest apartment available and at one point within walking distance of my job. At this age, this allows you to not go into further debt and start saving those initial seedling amounts for future investments. It also allows for the saving of a down payment, etc. Things typically get a bit more complicated in your 30’s and 40’s. By this time you might have a young family. You will be focused on more space, good schools and a safe neighborhood. All those things come with a cost. But how much?   RULE: Spend no more than 30% of gross (total before taxes) income on housing. Up to 40% if you have no debt. From the Federal Housing Association guidelines.

Here Are Some Examples:

$60,000 Income, $5,000 gross monthly income, Mortgage should be between $1,450-2,050 (the high end if not much other debts)   $80,000 Income, $6,667 gross monthly income, Mortgage should be between $1,933-$2,391 (if not much other debts)   $100,000 Income, $8,333 gross monthly income, Mortgage between $2,417-$3,417 (if not much other debts) In some parts of the country this is manageable and in others it can be very difficult given the high cost of housing. The main point is to at least stay within these targets, but as always try to beat them.  

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