Death is the debt we must all pay, but debt doesn’t have to be the death of us! In my last post I showed the dark side of compounding. Anyone with credit card debt is on the dark side. Today I want to discuss a little more about debt, specifically, good and bad debt. Not all debt is bad. Some debt is necessary for creating wealth. It is important to understand what‘s good and bad debt and how best to use them to ensure you are maximizing your financial resources.
Good debt can be summarized in one phrase “It takes money to make money”.
Good debt is money that you borrow to help you generate income and increase your net worth. You take a calculated risk of borrowing for the expectations of higher returns in the long run. Examples of good debt are: student loans, mortgages, leveraging and small business loans.
In theory student loans are a form of good debt. The rationale is that you take a loan to finance your education and after you graduate, your degree will allow you to land a high paying job. This job will then allow you to easily pay off your debt and then continue to generate income and grow your net worth. In reality, however, this is not the case for two main factors. The first is that your degree doesn’t guarantee that you will get a job after graduation. Second, if you do manage to get a job there is no guarantee that you will get a high paying job. The reality facing many students today is that they are leaving school with high levels of debt and can’t find jobs. Also student loans are not dischargeable even if you declare bankruptcy. The result is that we have a generation starting off their adult life in debt. Let’s consider the alternative, if you don’t take a student loan that means no degree. Not having a degree reduces your employability and competitiveness in the job market. Clearly there is a need for reform of the system, on the side of education (lowering tuition) or on the side of student loans (restructure the loans to reflect the realities that students face after graduation). What’s the verdict? Well, student loans still represent good debt until a better solution can be found.
A mortgage facilitates the purchase of real estate without having to pay the entire amount up front. Real estate is usually deemed to be a good investment because property values tend to appreciate over time. However, the sub-prime mortgage crisis in the US demonstrated that there are no guarantees for price appreciation. Also one has to remember that home ownership comes with a lot of financial commitments such as property taxes and maintenance fees, which are ongoing. Other factors being constant, real estate is a tangible asset. Regardless of how the winds shift you literally have a place to rest your head at the end of the day. Even though there are some risks and costs involved with real estate, taking on a mortgage is a good debt to incur.
Leveraging is using borrowed money to make an investment. In theory, it makes perfect sense to borrow money at a lower rate and use it to make an investment that would earn you over and above what it costs to take the loan. The usual hiccup is that there is NO guarantee. The potential gains may be tremendous, but remember, so are the losses. Leveraging is not for the faint of heart, it increases your investment risk and if you lose your investment you still have to pay off your loan (it magnifies your losses).
Here is an example of an investor who invested $5,000 shown in the first column. The second column shows his leveraged returns after borrowing an additional $5,000.
When things go well both investment options have positive returns with leveraging leading to $450 higher return. In the case of column one, if the investment tanked the investor will lose his investment of $5000. In the case of column two, when leveraging is involved the loss will be more than $15,000 ($10,000 investment plus the repayment of the $5000 loan plus interest). If you fully understand the risks involved and can afford (emotionally and financially) to lose your investment and prepay the loan, then leveraging will be a good option. If, however, you don’t have the constitution or the finances to able to bear the risk of your investments tanking then leveraging is not for you. Even though leveraging in theory is a good debt, it is one that should be entered into with great care.
A business loan is one which even though there are high risks involve it is one that I will encourage. People who start their own business tend to have a risk taking mindset and are usually innovators. Assuming that you have a good idea, you’ve done your research, you have a good business plan, you’re passionate and are willing to hard work, I would support taking a small business loan. One caveat is to start off with a small manageable loan. When your business starts to take off then you can venture further. If you have an idea to share with the world, do your homework and go for it, it’s worth the risk to fulfil a dream.
Bad debt occurs when you take credit or a loan to purchase an asset that loses its value the moment you take possession of it. Examples of bad debt are car financing, and any type of credit card debt used to finance consumable goods (clothes, shoes) and services (vacations).
A car is a necessity for many. Cars tend to be expensive and they start depreciating the moment you drive off the lot. This means that when making a buying decision about a car it should be based on practicality and on our budget not our ego. The marketers have done a lot to promote cars as status symbols. If you buy into this myth, then there is a tendency for you to finance a car that is beyond your means. Little thought is given to practicality and budgetary concerns in such instances. If you can put your ego aside, it is a good idea to pay cash for a used car if you can afford to or finance the least expensive model and pay it off as fast as you can.
Now we come to the most treacherous debt of them all, credit card debt. Let’s recall for a moment the role of the insula. As I referred to in a previous post, if you associate spending with pain, then the less likely you are to keep doing it because you would stimulate the insula which will produce emotional pain. Now, using a credit card rather than cash, bypasses the pain of spending because you don’t see the actual movement of the dollars. It is easier to swipe a card for a $500 purchase even though you know you probably shouldn’t, but you will worry about that later. Using a card to pay is less painful than actually parting with cash. Spending actual cash is not only more painful, but it is harder to ignore.
Note I am not advocating that one should stop using credit cards. In fact, if you know how to use a credit card properly, you have a lot to gain. There are two main reasons for you to continue using credit cards. The first is that you build your credit history and when you pay on time your credit score increases. This allows you to have access to good debt which can be used to make you more money. Secondly, there are a lot of reward programs from free air miles, cash back and free food. I say take advantage of it all! Once you are able to pay off your credit cards on time, you can use the cards to your benefit. In and of themselves, they are not evil. It all depends on how you use it. The trick with having and using a credit card is to follow these basic rules:
- Make sure your purchase is adding real value and not some perceived value that you can’t afford. For instance buy the shoes that look good and cost under $200 and not the one that is a brand name and costs $1500. Buy based on your budget and not on your ego.
- Understand that a credit card is not free money. It allows you to use the money interest free for a couple of weeks. After which, if it is not paid, you start accruing interest on the balance. By all means, use your credit card to make purchases for which you don’t have cash right now, but make sure that you can pay off the bill in full on the due date.
As we can see, not all debt is bad and if we follow some basic rules we use debt to our advantage. Think of a debt as a knife, in the wrong hands it can cause murder and mayhem. In the right hands it can be used to carve a masterpiece. Use your debt to create a masterpiece not mayhem!
What having you been creating?