Good Debt or Bad Debt – Which one you have?
Today we’ll talk about a strategy that can help you build wealth – borrowing.
Most of us are borrowing for one or the other reason. It could be either for logical or emotional reasons. A logical reason is to buy a home now because you believe there will be long-term growth – an emotional one is to get that latest big screen TV or mobile phone today because you must have it now and can’t wait to save up for it.
Debt, of itself, is not a bad thing – but you need to understand that there is bad debt and good debt. It depends on you whether you want to have good debt or bad debt. It depends on your financial habits. Good habits will help you to generate wealth and bad habits will make you struggle to pay the bad debt.
Let’s understand the concept with the help of an example. There are two friends, Mahesh and Amit. Let’s assume Mahesh has good financial habits and Amit has bad.
Mahesh always looking for borrowing at low rates and buy growth assets like property, shares, gold. etc. while Amit borrows at high-interest rates to buy depreciating items like a car, a mobile phone which will be worthless after few years. Aside from asset value appreciation, Mahesh also enjoys the benefits of tax rebate since the assets he bought is eligible for it.
Amit decides lifestyle is a priority – He take a loan and purchase a car worth 10 lakhs. The interest rate for his loan is said 10% reducing for five years. He will have to pay total 12.75 lakhs and after five years his car value will be somewhere around 5-6 lakhs. So he incurred a loss of 7.75 lakhs (5 lakhs depreciation + 2.75 Interest). After five years he will have nothing much to show for it.
Mahesh has taken a loan of 10 lakhs at 10% and invested in equity stocks and funds. After five years his portfolio would be around 16 lakhs (assuming 12% returns) so even after paying interest @ 10% his net gain would be 4-5 lakhs.
Both have spent 12.75 lakhs in 5 years – the ones who bought the car probably still battling, the others have an equity of 4-5 lakhs in a portfolio that could now be left alone to grow while funding itself for the rest of their lives.
It is always good to have some debt on you, provided your spending habits are also good. Debt also helps to keep you going and earn more and more for repayment. You will have pressure(liability) to pay off your debt and that keep you going. Most of us know this rule but sometimes logically or emotionally we take the wrong decision (bad habit) which is not allowing us to grow our wealth.
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