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The Difference Between Good and Bad Debt

The Difference Between Good and Bad Debt
Image credit: Illustration © David Schwen

Put it on plastic

It's something of an entrepreneurial cliché, but you can always use credit cards to fund your business. Just save them for short-term needs--when you need a few weeks, not months, of float on your money to obtain an immediate return. This can be for items such as a booth at a trade show, a last-minute sales trip to land new business or an emergency vendor payment.

I don't like debt. For nearly a decade, I've written about personal finances, both my own and those of others. And too many times I've seen how debt can act like a cancer, draining life from healthy bank accounts.

That said, debt can sometimes be used for good. It's OK to take on reasonable debt to pay for the few things that are likely to hold or even increase their value: an affordable mortgage (the key word being affordable), student loans or financing for a business.

As I'm sure you know, many businesses have cash-flow problems, and a loan or line of credit can smooth the ups and downs until the company gets through the rough patches or grows into a more stable income producer. Whether a person goes through a bank, a loan company such as Lending Club or Uncle Charlie from Allentown, the basic rules of securing credit still apply.

Prepare yourself. Before lending you money, a bank or other group will want to see a business plan and current financial statements. They'll also check your personal credit history, so be sure your credit score is excellent.

Shop for the best terms. If one bank wants to give you a loan, it's likely another will, too--and at a competitive rate. Just make sure to read contracts closely and ask the right questions to ensure you are being offered a better deal.

Borrow only what you can afford. Avoid the temptation to borrow more than the absolute minimum you need, no matter how much you are qualified for.

Debt isn't evil, but it can be dangerous. Use it wisely, and it can give you a financial edge, providing the flexibility to seize opportunities you otherwise couldn't afford and ones that could push your business to the next level.

That said, always remember: The best debt is one that has been repaid.

Put it on plastic
It's something of an entrepreneurial cliché, but you can always use credit cards to fund your business. Just save them for short-term needs--when you need a few weeks, not months, of float on your money to obtain an immediate return. This can be for items such as a booth at a trade show, a last-minute sales trip to land new business or an emergency vendor payment.

 

The 36% Ratio

How do you determine how much money you can borrow--or, more accurately, how much you should borrow? Most experts recommend a personal debt-to-income ratio of less than 36 percent. That is, your total monthly debt payments (including mortgage) should be less than 36 percent of your gross income. If you make $60,000, you don't want to borrow more than $21,600.

I think it's smart to apply the same ratio to business loans using a ratio of debt/liabilities-to-assets. And if you can keep your liabilities below 20 percent of your assets, that's even better. --J.D.R.

J.D. Roth is the founder and editor of the personal finance blog getrichslowly.org and the author of Your Money: The Missing Manual.

Like this article? Get this issue right now on iPad, Nook or Kindle Fire.

This article was originally published in the November 2013 print edition of Entrepreneur with the headline: Reasonable Debt.

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