While some people are wary of debt, others gladly use loans for both major purchases and regular needs without considering the consequences. You may wonder what strategy is better for building wealth, and the right answer is “something in between.” In fact, not all debt leads you to stress and ruins your life. On the contrary, some types of borrowing money can create passive income, help you improve your budget management skills, or even reduce your existing debt. But most people still don’t understand how to use debt to build wealth and stay away from both good and bad debt.
If you wonder how debt can create wealth, the answer is on the surface. If you use the money in ways that enable you to build wealth, borrowing money might be beneficial. On the other hand, borrowing money might be detrimental if it leaves you broke and in debt. Below, we describe several debts and how you might use them to your advantage.
The short answer is yes, it is possible. However, you need to keep in mind that not all debt will improve your financial situation. On the contrary, bad debts at high interest rates can trap you and result in various financial difficulties over time.
At the same time, when you come with good debt that you use for your benefit, for example, to purchase an investment property, the situation changes significantly. Good debt can help you build wealth by using the income generated from assets to make loan and interest payments and manage the rest of your cash flow to make more investments.
Thus, when you’re going to get a personal loan, ask yourself what your borrowing goal is. Of course, it’s not always possible to be pragmatic. Sometimes you may get into a financial emergency and need to borrow money to cover your current expenses or regular spending. This way, you won’t reach financial success but will be able to cope with financial difficulties without stress. However, when it comes to building wealth, you need to have a plan or a long-term strategy, estimate all risks, and have a clear understanding of what good and bad debt are.
It is customary to divide debt into good and bad. There are several factors that define which debt falls under each of these categories. This way, knowing them will help you differentiate good debt from bad one. As you probably have guessed, the main distinguishing feature lies in what you’re going to spend the money for. For example, personal loans that people take out to cover their wants are not the same personal loans individuals use to start a business because of the different results they entail.
Besides the way you use your loan funds, there are a few more factors that differentiate good debt from bad debt. The following two metrics are the annual percentage rate and the period of time it will take you to pay off your loan. In addition, your particular debt tolerance and risk tolerance should both be taken into account. But let’s take a closer look and give several examples for a better understanding.
Good debt, also known as efficient debt, is a type of obligation you use to make purchases that have the potential to generate long-term wealth for you. This way, you can consider it as a part of your investment strategy. It allows you to put money into appreciable assets and get some benefits from it over time. A home loan is an example of good debt as it allows you to get an asset that will bring you benefits in the end.
A form of obligation with a high cost or a high level of risk is referred to as bad or inefficient debt. Credit card debt is the most prevalent type of bad debt. It is considered so due to its high cost and the way most individuals use their credit cards to make within-credit purchases. Another example of bad debt is a car loan. It is considered bad because you borrow money to purchase a depreciating asset that goes down in value.
Summing up, good debt is a borrowed amount that you get on reasonable terms and use to build long-term wealth. In its turn, bad debt is a type of borrowing that bears only the debt itself that reduces your wealth because of associated interest and additional charges. Bad debt doesn’t come with any profit you can gain after some time.
You can take a number of actions to manage your personal finances so that you can begin using debt to make money and help you advance your financial goals. Here is our top five:
Creating passive income streams by using good debt is a strategy that professionals use to build real wealth. There are various investment strategies that can help you with this. You may have even heard of margin investing, leveraged ETFs, hedge funds, and short selling before. Sometimes using debt can help you get several times more annual returns than if you used only your own money.
Use a debt recycling strategy that aims at helping you replace your bad debt with one that generates capital growth or is tax deductible. For example, when you use equity in your house, you can invest in assets that might produce income and potentially grow in value.
Debt consolidation can help you reduce your overall interest payments by replacing a higher-interest debt, for example, your credit card balance, with those with a lower cost. This way, you can increase your mortgage and use the remaining sum to pay off several inefficient debts.
You can use good debt as an auxiliary tool to start a business. If your business becomes successful, it will generate income and create wealth. If you just started your way toward becoming an entrepreneur, it may be difficult for you to qualify for a conventional business loan until you’re in business for at least six months. Therefore, a personal loan can help you out.
House flippers are people who purchase houses, make all the necessary home improvements, and resell the property for a profit. This way, buying a house can also be considered an investment. You can purchase residential real estate with the help of a loan, fix it, and rapidly flip it for a profit. Although this approach comes with risks, it can help you create wealth if you know what you do.
Obtaining debt can sometimes play into your hands. However, if you want to use debt to get rich, you need to have a plan along with a clear understanding of what type of debt you should use to reach your goals. There is no simple answer to how to use debt to build wealth. It’s always a personal choice that is based on your particular situation. However, there are a few options that can lead you to the desired output.
When you decide to use debt to make money, don’t forget about cash-flow management. If you’re a beginner, seek a financial adviser to choose the right strategy. Also, keep track of your debt-to-income ratio to make sure you don’t overburden yourself.
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