Good Debt vs Bad Debt

 

It was Shakespeare who wrote, “Never a borrower or a lender be, for loan oft loses both itself and friend.”  These words, although written for a play (Hamlet) are wise and prove often to be true.  Borrowing can lead to unwanted consequences.  But, is borrowing and taking on a measure of debt always wrong?  

A question I often get when I’m teaching on debt is, “What do you think about good debt vs bad debt?”  Personally, I don’t like that question.  It implies that debt can be “good” or “bad,” something equated with morality when in essence debt and borrowing are not moral issues.

When people say “good debt” they generally mean borrowing for appreciating assets or an investment that will generate an income.  When they say “bad debt” they mean borrowing for depreciating assets.  Appreciating assets like real estate, art, precious metals, usually hold or grow in value over time, while depreciating assets like cars, boats, furniture, lose value over time and may even cost money to maintain.

When you borrow to purchase items that increase in value and produce an income, you’re acquiring assets.  When you borrow to purchase items that decrease in value and even cost you additional money to maintain them, you’re acquiring liabilities.  As Robert Kiyosaki, the author of Rich Dad Poor Dad put it, “Assets put money into your pocket, liabilities take money out of your pocket.”  My view on borrowing is not that it is good or bad, but that it’s either wise or unwise.

When is borrowing unwise?

When we were in our early twenties my wife Natalie and I borrowed to purchase a new car.  We didn’t put any money down and financed the car for 5 years.  Shortly after we purchased the car we had to reduce our expenses and the car payment seemed like a good place to start.  Unfortunately, the value of the car was now worth less than what we owed on it, so we were stuck with the car and the payment.

Although we didn’t know it at the time, the choice to borrow 100% for the purchase of the car was unwise because the price of the car depreciated faster than we were able to pay down the loan.  Moreover, the fact that we couldn’t get out of the payment made it difficult to budget and move ahead financially for several years.  This one purchase caused us to stall and even regress in our journey to financial health.  When borrowing causes you to “lose ground” and diminish rather than increase your financial well being and net-worth, you’re making an unwise borrowing decision. 

5 indicators of unwise borrowing

  1. Unable to easily make the payments.
  2. No savings available to pay off the loan if necessary.
  3. The payment causes you to rob or underfund other areas of your budget.
  4. Unable to save enough or at all for the future.
  5. The item purchased is a liability, costing you additional money to maintain.

When is borrowing wise?

Borrowing can be a great way to leverage other people’s money to grow and acquire more wealth for yourself.  If done wisely, the benefit can be significant.  

Several years ago Natalie and I purchase a rental property.  We put a 25% down payment and borrowed 75% from a bank.  Over the past 6 years that we’ve owned it, the property has made more in profit than what we initially invested into it.  Additionally, the value of the property has increased by 130%, increasing our equity from 25% to 70%.  By leveraging the banks’ money we were able to acquire an asset that has increased our net worth and created an additional income stream.

Of course, when borrowing to purchase any assets there’s more to it than just qualifying for the loan and signing on the dotted line.  When borrowing you must understand the asset, it’s potential for income or growth, doing the due diligence before the purchase, and manage it wisely after the purchase.  Although not the focus of this blog, these things should be carefully considered in order to make a wise borrowing decision.   

5 indicators of wise borrowing

  1. Enough margin exists to easily make the monthly payment.
  2. The payment does not negatively affect your ability to provide for personal needs.
  3. If necessary, the asset can be sold relatively quickly to satisfy the loan.
  4. The asset has good potential for monthly or yearly profit.
  5. The asset has good potential for growth in value in the near future.

Conclusion

Borrowing is wise when used to purchase appreciating assets or to fund a venture such as a business that has the potential to grow in value and produce a profit.  However, borrowing should not be done to excess nor done over a long period of time.  Many investors pre-2008 were borrowing to invest in real estate and over-leveraged themselves by only looking at the upside.  Many of them would have saved themselves a lot of trouble by borrowing wisely, being more cautious and better prepared for the downturn.  

When borrowing you should always hope for the best but prepare for the worst.  Consider the downside and be prepare for it.  Having margin (the gap between income and expenses) is vital to your success because it provides you with the ability to manage through a down cycle.  Too many people fail to manage their assets well, have no margin, and suffer when expenses which are often quite predictable occur.