Rule #1 Finance Blog

With Investor Phil Town

The Difference Between Good Debt and Bad Debt

Before you start investing, it’s important to take a look at your personal finances and eliminate the most important barrier to successful Rule #1 investing…

And that is to get rid of bad debt.

Let’s assume that you’ve:

  • Found at least one business that has meaning to you—that you would be proud to own and that you understand.
  • Researched the management, googled the company, read the articles, and went to the company’s website and read annual reports and the CEO’s letters.
  • Done all of your 4Ms homework.

You’re thinking about dropping money into a trading account and buying that company’s stock.

Before you take the leap, though, you need to make sure you’ve eliminated bad debt.

Let me explain the difference…

Get the free tool that calculates exactly how much you’ll need to retire comfortably.

Good Debt vs. Bad Debt

Yes, there’s good debt and bad debt.

Good debt is money you borrow at a low rate of interest, with which you make a high rate of return.

A good example is the money you borrow to buy an apartment complex. The debt is covered by the rental income—or it will be in a few years.

Bad debt, by contrast, is consumer debt—money you borrow at a high interest rate to buy things that don’t produce income or grow in value. These are things like cars, refrigerators, clothing, and trips to Europe.

All of us have done it, and all of us have paid the price.

The price of bad debt is the impact of compounding rates of return working against you instead of for you. If you have credit cards or bank loans costing you 18% or more a year, that’s 18% compounding against your retirement.

Since Rule #1 is all about not losing money, the first thing most of us must do to become successful Rule #1 investors is to pay off bad debt.

Think about it…

If our target rate of return for Rule #1 is 15%, and we have credit card debt we’re paying 18% on, essentially that means we’re borrowing money at 18% and making only 15% on it.

Even though we’re doing well as a Rule #1 investor, we’re going backwards at the rate of 3% compounded per year. That’s a heck of a barrier to successful investing. The only way you’ll get rich that way is to hit the lottery. Otherwise, you’re going broke with great certainty.

But, if we turn that around and take the money we were going to invest and instead pay off the 18% interest-rate debt, then instead of losing 3% a year, now, even if we don’t have any money left to invest, we’re at least breaking even and we’re not violating Rule #1. And as long as you don’t violate Rule #1 and you keep on practicing, learning, and saving, you’re going to be rich one day.

If you want to calculate exactly how much you’ll need to retire comfortably, click the button below to get my free retirement calculator.

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Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.