Good debt management advice is hard to come by.
Traditional financial wisdom states that certain debts, such as mortgage and student loans are good debts, while most other debts such as credit card debt, car loans, etc… are bad debts.
On the other hand, many Personal Finance bloggers express the opinion that ALL debt is essentially bad, to be paid down as quickly as possible, sometimes even at the cost of establishing a sustainable savings plan for the household.
So what is the truth?
In truth, the good debt vs. bad debt determination is not written in stone and needs to be evaluated based on each individual’s unique situation.
In this article, we will not offer any prescriptive ‘facts’ but will try to establish a few guidelines that the readers can employ in their own situations to make the determination for themselves.
It is important to understand that there are two distinct stages of any debt.
Stage 1 is the decision stage when you are trying to determine if you should take on a new debt. This is a key decision point as it will likely determine your future relationship with the debt (should you take it on) and the asset that you acquire with this debt. This is also, most frequently the time when not enough thought is devoted to the decision process, as we are more likely to be intoxicated with the possibilities with the asset we are going to acquire and are not able to be rational about the financial aspect of the acquisition.
Stage 2 of the debt is after the debt has been acquired. Here the decision process changes and the question now becomes whether it makes sense to keep carrying the debt as it is or should it be paid off as quickly as possible. It should be noted that in some cases, what we determined to be a good debt in Stage 1, may actually turn into a bad debt in stage 2, sometimes due to factors beyond our control. In stage 2, it is important to realize the the debt is yours and you can’t do anything about it except to find the best way to handle it.
In this article, we will focus on Stage 1 of the debt.
Stage 1: Choosing to take on a new debt
When debating whether to take a new debt on, it is important to focus on two key points: What is the nature of the asset that you wish to acquire with this debt and what is the cost of the debt? A good debt is always goal-based. Goals need to positively address your personal finance or lifestyle issues. A goal on the lines of: I need to buy the latest iPhone is not what we are talking about here. You also need to have a defined project in mind and a plan to accomplish your goals for the project. Debt incurred for impulse buys are never good debts.
What is a good debt?
A good debt is a debt that allows you to acquire an appreciating asset. Essentially, the value of the appreciation or income production needs to be greater than the cost of the debt that you are taking on. Which basically means that in current dollars, the total gain from the asset over the life of the debt is greater than the total interest and costs you incur on the debt. A few examples of good debt are:
- Taking a student loan to pursue a graduate degree, which will result in greater income potential for the lifetime (see some student loan repayment options). Here the asset you are acquiring is the new/upgraded skills and career marketability.
- Buying an income producing property with additional possibility for capital appreciation.
- Buying a car if it is necessary for you to perform your new job. Please note that buying a car on debt is not always bad as long as there is a good reason for it.
- Buying a vacation home that you plan to use to write your next masterpiece novel.
- Mortgage, when you are buying a house that is likely to appreciate at a rate greater than inflation (at least, best if the appreciation rate over the term of mortgage is greater than the interest rate on the mortgage) and it provides other quantifiable and/or intangible values by greatly improving your lifestyle.
These are all good debts because they potentially create more financial value than they destroy. Please note that as most life decisions, this is not risk free. You may never get to finish that great novel or your graduate studies due to other circumstances but if you have put a great deal of thought and planning behind these projects than a large amount of risk is mitigated.
What is a bad debt?
A bad debt is a debt that allows you to acquire something with short term value, mainly for immediate consumption. These tend to be impulse buys. A few random examples would be
- Buying the latest and greatest HDTV on credit when your existing TV works as well (note: that this may be a good debt if you can justify the value: for example, if you plan to install the TV at the bar of the restaurant that you own so you can show football games and in process keep the patrons lingering and ordering more of your brew).
- Using credit cards for your regular grocery shopping, if you regularly carry balance. On the other hand, if you are diligent about paying off your balance every month and use credit cards only for convenience and miles/points, then it is not a bad debt.
- Buying or leasing a new car every couple of years on credit.
- Mortgage, when you are buying a house at prices or location where the appreciation potential is severely limited or at a high rate of interest.
Additionally, you need to consider the cost of the debt to determine if the debt is good or bad.
Your money is valuable and can be saved/invested in many different ways to get you a rate of return.
The question you should ask is whether it is cheaper to go into debt or should you pay cash if possible. If you can get better returns for your cash elsewhere than the amount of interest you will save if you pay in cash, than by all means take the debt on.
All this amounts to a certain level of analysis at first but once you get the gist of it, this analysis will and should become a second nature.