Good debt and bad debt
When it comes time to spending money, I can still hear my dad saying “Don’t spend money you don’t have.” Unfortunately, spending money we don’t have has become all too common. Personal debt is rising too fast and getting credit has become easier than ever.
Few people will argue that having too much debt is a bad thing. It can be financially destructive. Just look south of the border to see what too much personal debt can do to personal lives, governments, and even corporations.
Although too much debt is bad and less debt is good, it is important to understand that there are different types of debt (most of it is bad but some of it is actually good).
Bad debt is pretty easy to define. It is debt that does not benefit your financial future. Most debt these days is bad debt because it is used to enhance lifestyle as opposed to enhancing wealth. Debt used to buy big-screen televisions, furniture, cars, and vacations are common examples of lifestyle debt. At the end of your purchase, there is little to no productive wealth to show for your debt. Here are some examples of bad debt:
- High-interest debt. It’s pretty obvious that high-interest debt is not good. Paying 18% or more is not a good financial strategy. Many credit cards charge ridiculous interest rates and worse yet, too many people keep balances on these high-interest cards.
- Car debt. Cars depreciate in value. In other words, you are losing wealth, not gaining it. Canadians love their cars but try living with fewer cars, less debt and drive it longer. Cars are terrible investments. Going into debt to buy a terrible investment is a terrible financial strategy.
The best way to avoid bad debt is to start thinking more like my father and others of his generation. It’s not fun but there’s something smart about it.
Good debt, on the other hand, is debt that is used in financially productive ways. Good debt is debt that creates an opportunity to enhance wealth, income or cash flow. Here are some examples:
- Mortgage. A mortgage is generally used to buy a home (often your personal home). The reason this is good debt is that you are borrowing money to buy something that appreciates in value. A house is an asset that has value and hopefully increases over time. Homeownership not only is financially productive because real estate increases in value but also because it teaches people to be more fiscally responsible.
- Leverage. Leverage is a concept that has been popularized by the financial industry. Financial advisors often promote the merits of borrowing money to invest in stocks or mutual funds. Conceptually, leverage works as long as the investment (after-tax) increases in value more than the after-tax cost of the interest. The bonus is that if set up properly, the interest on the loan is tax-deductible. Business loans are another example of leverage since the intent is to invest in something that makes money or creates cashflow.
- Education. Since your income from work is probably one of the biggest potential contributors to wealth, investing in an education that will give you greater opportunities to earn more income is a good thing. Borrowing to enhance your education can be a form of god debt.
As much as these may be good forms of debt, moderation is still the key to financial success. Even good debt can be destructive if you have too much. Just ask people that have bought too much house (or too many houses), borrowed to invest in a terrible investment or paying for student loans long after graduation.