The simple view is that you should avoid any debt, and if you can’t avoid it, you should pay it off ASAP.
That’s a good attitude to have, and there’s nothing wrong with it.
There is another school of thought though which is even better at creating wealth. There is such a thing as ‘good’ debt, and this should be used whenever possible.
‘Good’ debt is any debt that, while it’s still a debt, costs you less to have than you make by having it.
For example, if I can borrow $1,000 at a cost of $5 a month. I’ll still have to repay the $1,000, but it also costs me $5 a month. Bad right?
Now let’s say I can invest $1,000 in something that’ll make me $10 a month. If I borrow $1,000 and put it in that, I’m paying $5 in interest but making a return of $10. That’s $5 a month profit.
So if I borrow the money, I can make a profit of $5 that I wouldn’t be making if I didn’t borrow the money. So borrowing the money would be a ‘good’ debt.
The money you borrowed gives you what the financial world calls ‘leverage’.
It works the same for one-off investments too. Say you can invest $1,000 for 12 months, but in a year you’ll get back $1,100. Twelve months of interest on borrowing $1,000 at $5 per month is $60. So, as long as you can spare the $5 a month, you’re paying $60 over a year to make $100. A profit of $40.
The critical thing to remember here is that it’s only a ‘good’ debt if it makes you money. Any debt that costs more than it lets you make is a typical ‘bad’ debt. So pay attention to interest, charges, costs, the tax you’ll have to pay on what you make, etc.
If you’re not completely sure that a debt will be ‘good’, you should assume it’s ‘bad’ and avoid it.
Borrowing money for leverage is riskier than doing nothing. When it works, you’ll make money. When you’re wrong about it being ‘good’, you’ll lose money.
For example, let’s say you put $1,000 in expecting to get back $1,100 a year later, but you end up only getting $950 back. If you borrowed $1,000 at $5 a month interest, you’ve paid out $60 in interest and you’re $50 short of paying back your loan. That’s a loss of $110.
So don’t do this with anything you’re not sure will be ‘good’, and don’t get in over your head. If in doubt, play it safe and don’t borrow.
However, if you are sure, but you could cope with being wrong, then you’ll make more money on average if you use leverage.
Leverage is so-called because it acts like a ‘force-multiplier’ for your money, like a lever does for physical force.
If the investment is beneficial enough compared to the costs of the leverage, then you’ll make more money because you can invest more.
On the other hand, if the investment doesn’t work out, then you’ll lose more money because you invested more and you have the costs of the leverage.
So it’s a tool to be used wisely.