Good Debt and Bad Debt: What is the Difference?
Warning Order
Struggles with debt are common for most people. When companies are eager to offer loans or credit cards to help buy their products and services, it’s easy to get caught up in the “low monthly payment” or “0% interest for 12 months” traps. But not all debt is bad. We can use debt in a responsible, positive manner, too. Most people classify good debts and bad debts based on categories, like mortgages being good and store credit cards being bad. I take a different approach, one more akin to treating individual debts like corporate debts. From this viewpoint, we can justify certain debts based on their purpose and potential returns for the user.
Situation
Much financial advice is dedicated to managing and paying off our debts. In the United States, free flowing credit offers make the process of accumulating and then overcoming significant debts a part of nearly every adult’s experience. Add enough credit cards, car loans, and a mortgage with a little sprinkling of student debt can quickly eat up a paycheck with monthly payments. Even without a mortgage, one must put a roof over their head. The best case scenario with significant debts is that people spend most of their paychecks on monthly payments and living expenses, leaving little for things like saving for vacations or investing for future goals. The worst case is that someone loses their income for one reason or another, and all of a sudden have no way to service their debts. For a person or family that does not have sources of income independent of their job, this scenario spells disaster. For that reason, many people swear off debt completely.
While some take the perspective that all debt is bad, others believe that certain categories of debt, like mortgages, are good, while other categories, such as credit cards, are bad. I take a different approach. First though, debt needs to be controlled as part of any financial plan. Debt of any kind reduces the flexibility of a budget or financial plan and managing and reducing debt is one of the topics on which I spend the most time with my clients.
Coordinating Instructions
When taking on new debt, many people should analyze the decision as if the debt were an investment. For example, a company might borrow money to purchase more efficient robots for an assembly line. Or it might borrow money to construct a new office building. Universities dedicate entire finance courses to the analysis of how to best fund corporate investments, but I don’t need to be as complex to make my point.
The basic tenet of an investment decision is that the return on the funds used is greater than their cost. Suppose I was about to interview for my first job after leaving the Army and the appropriate dress for the interview was a suit. Let’s also suppose that I didn’t have cash to pay. If I’m going to use a credit card at 20% interest to make the purchase, I better earn a return higher than the interest rate. On a $500 outfit, simple interest is $100 per year. If a cost conscious clothing purchase helps me land a job making $40,000 per year, the debt is well justified and I could pay it off in short order. I must caution that this scenario isn’t meant to support purchasing a $2,000 suit, though. It’s unlikely that spending the extra $1,500 will earn me a higher paying job.
Continuing this though process, let’s say that I need a car to travel to and from this new job. I could lease a car for $200 per month for 3 years. The total cost for this car would be $7,200 during that period. Leases have internal interest rates, but without even considering a specific rate, it’s easy to see that spending $7,200 to help earn $120,000 over 3 years makes sense.
Command & Signal
I could go on with examples that justify using debt to finance the purchase of products and services. The key is to avoid being excessive in using debt. In our car example, we can justify leasing a reliable, safe car at $200 per month. We cannot justify leasing a car at $800 per month in this case. To consider debt as an investment in ourselves, our families, and our careers, we must be disciplined and selective in its use.