Good vs. bad tax debt – What is the difference?
So, What is Good and Bad tax debt?
The most commonly used definition is that bad debt is “debt that makes you poorer”. And with that said many would think that all debt is bad, because you always pay interest on your loans, and therefore the loans makes you poorer, right? Well, although you always pay interest (Unless maybe you borrow from some close relative or something like that) not all loans wrecks your finances. Of course any type of payday loans or other high interest loans would be considered bad debt. Buying a car, financing a big party or going abroad for borrowed money certainly also would be bad debt. Conversely, keeping a business afloat by incurring tax debt, in some cases may be fine.
But what about buying a house, or an apartment? Is that bad debt? Well, it depends. Of course you have to pay interest, but in this case you also have to consider that over time real estate prices tend to go up – and the prices often tend to rise with a higher annual percentage than the interest rate. Therefore, borrowing to buy a home might actually make you richer, since the appreciation of the property often is bigger than the amount you pay in interest. And there we have what is usually called Good debt – “Debt that makes you richer”.
So, as I wrote earlier bad debt usually occurs when someone borrows for consumption, or pay for a failing business. And good debt instead occurs when someone makes an investment in an appreciating asset – like real estate for example. Therefore, borrowing to buy stocks, funds, real estate and other types of investments is typically seen as good debt. The only criteria is that the investment have to have a higher return on investment than what the interest rate is. And generally for example both stocks and real estate tend to generate returns significantly higher than the interest rate.
For example the S&P 500 has generated, on average, close to 6-8% returns the last 100 years, while the interest rate usually has been a lot lower. This is also how many investors have become very rich – by borrowing money to invest and thereby leveraging their own money to create greater returns on their own capital. This is not the case with a failing business, where it would be a mistake to incur tax debt to just prolong the life of the failed business.
So, to sum up, one of the best advice for you to get better finances is to get rid of all bad debt and start accumulating some good debt. If you have tax debt, realize it is expensive debt and you may even need a payment plan to pay it down, but in some cases worthwhile if the long term business prospects are good.