In a previous post, I outlined the 7 levels to win at the game of financial freedom. In this post, I thought I’d outline a little about Level I — tackling all bad debt. First, let’s distinguish what makes debt good or bad.
Good debt is debt that helps you, currently or potentially, produce more. Student debt, ostensibly, will help you generate more income in your career, therefore it’s considered good debt. Corporate borrowing that helps you grow the company is good debt. Even mortgage debt is considered good debt because it stabilizes your 2nd biggest expense, the mortgage and allows you to own a real estate asset. Most all good debt has advantageous treatment in the tax code (meaning the interest on good debt is generally tax-deductible). So what is bad debt?
Bad debt typically comes from consumption. It’s credit card debt. It’s auto-loan debt. This debt is not helping you produce more; it’s all consumption based. If you’re not building to produce more income or potential capital appreciation, then it’s bad debt. And, typically bad debt has no favored tax treatment (it’s not tax deductible).
The most important aspect of Level I of the game to win financial freedom has 3 main lessons to learn. One, is to be able to budget. You’ve got to be able to create a budget and stick to it. If you can’t do that, it’s hard to get ahead in other parts of the game. Two, is that you pay yourself first. Too many times, when some spending goes over in the budget, everyone else gets paid but yourself. The store gets paid, the rent gets paid, the credit card gets paid, but somehow you don’t have money to pay yourself. Learning to pay yourself first, before you pay rent or anything else, is a critical life-lesson to learn at Level I. Three, the final lesson to learn is to be able to produce more than you consume. You can do that by either limiting spending or producing more income. It’s with the extra production capacity that you’ll be paying of all your bad debt.
I would say you’re generally ahead of the game if you can get all your bad debt paid off in your 20’s. It’s hard because your big producing years aren’t coming until your 40’s and 50’s. But, if you learn the 3 big lessons of Level I while you’re not making a ton, then that will help you all the more when you’re on Level II and beyond. And, learning these lessons at the beginning will be critical to building a solid foundation in your financial education.
Next up is winning Level II — Start a retirement account & add 10% per year. More to come next week.