Good versus Bad Debt

“If you can’t afford something, don’t borrow money and buy it.” — my mother

“If the debt you take on helps you generate income and build your net worth, then that can be considered positive.” — Investopedia, Debt Management Guide

Happy New Year! It’s January 1st, 2023 and I’ve been debating which of the topics I’d like to write about should be the first of my posts in 2023. I’ve finally decided to write about Good Debt vs. Bad as so many people are making resolutions for the New Year and this subject should provide good input into a meaningful 2023 resolution.

When managing one’s finances, a good rule of thumb is to avoid taking on debt. However, avoiding debt isn’t a hard and fast rule. There are some times where it is worthwhile to take on debt. Today’s post is about differentiating between good vs. bad debt and highlighting some ways to leverage good debt to strengthen your long-term finances. I hope you use the learnings from this post for a 2023 resolution to change the mix of your borrowings to have more good vs. bad debt.

Why does most financial advice recommend avoiding debt?

Debt is just a fancy name for money that you borrow. There are many different ways to borrow money (see my article on What is Debt? And why most financial advisors recommend avoiding it for more details), but they all share the same requirement that you pay back the money that you borrowed with the interest that lenders charge.

Most financial advice recommends that you minimize debt. That’s because the majority of consumers’ borrowing is for what I call “bad debt”. This is debt which funds:

• Consumption: Borrowing money to purchase something that you use up quickly. You enjoy the benefits of that purchase today, but the purchase you made doesn’t last very long. Once it’s used up, you no longer have what you purchased, but you are left with the debt incurred to buy that item. Examples of this can be as small as the latte you purchased today at the coffee shop or as large as the vacation that you went on last year. Some of these items you can afford, but others you can’t and need to borrow money to buy
• Purchasing depreciating assets: Purchasing items which last a while, but depreciate in value. A good example of this is buying a vehicle. Every day you own it, it is worth less than the previous day whether you use it or not. The debt that you incurred though is not worth any less. You still have to pay back every dollar you borrowed plus the interest on that debt. Now, assets like these are sometimes necessary because you need a car to get back and forth to school or your job. However, for such assets, you can minimize the amount of debt you incur by buying the lowest-cost product which meets your needs such as buying a value brand instead of that luxury vehicle you and your friends all aspire to

Debt has costs that need to be paid. Beyond paying back the money that you borrowed, you will need to pay the interest on those borrowings, which can oftentimes be a very large amount. That’s money which you could have used for other purposes. In addition, debt has indirect costs such as constraining your financial options due to the requirement that you prioritize making your debt repayment. For all these reasons, the rule of thumb of minimizing debt is a good one to live by.

What is good debt?

Not all debt is bad though. Good debt can be incurred by investing in building your long-term financial future. The way to determine if a debt is good is by looking at the balance of costs and benefits of that debt:

• Cost of debt: The interest cost of the debt as well as the constraints it places on your overall finances (i.e., does all of your cash flow have to be directed to repaying that debt?)
• Potential benefit of the investment: The long-term impact on your earnings from that investment. This equals the estimated value of the sum of current and ongoing income plus the increase in value over time. Investments which grow in value are in contrast to consumption purchases which don’t have any positive impact on your earnings. See below for examples of good investments and how to quantify the impact on earnings

Look at the balance of the costs versus benefits after adjusting for the time value of money. If the benefits outweigh (and ideally, vastly outweigh) the costs, the debt incurred is a good debt. Now, you won’t have perfect information on the benefits of your investment so you have to do your best job at determining the potential range of those benefits and then taking a reasonably informed risk based on the ratio of costs to benefits.

Examples of good debt include borrowing for:

• Education which builds your long-term earnings: Investing in building your skills and capabilities (your human capital) is a great way to increase your lifelong earnings. However, you have to make sure that what you’re studying will actually have a payoff of increasing your earnings — college loans to fund education which has higher longer-term benefits than its cost can be a very good form of debt. You do need to do the cost/benefit analysis though as a lot of people incur college loan debt for education that does not sufficiently increase their lifestream of earnings to justify the cost of the debt
• Investing in assets that have long-term income + capital gains that exceed the cost of the debt: Investing in assets such as real estate at a price where you can earn more than the interest you pay is another form of good debt. When used judiciously and with a large safety cushion, leverage (a fancy way of saying borrowing money for investing) can increase your long-term earnings. Make sure you’ve done all your due diligence on these investments though and that you have a large safety cushion. Leveraged investments where the asset rises can turbocharge your results, but when those assets decrease in value, leverage can be very dangerous as your lender may require to forfeit the asset or sell when the price is very low. I will write an article in the coming weeks on how leverage turbocharges your investments when prices go up, but can destroy your investment on the way down
• Investing to start or grow a business: Building a business takes capital. When you have a good idea which you are willing to put the time and effort to build into a business, borrowing money to fund that business can be good debt. Be clear eyed before you dive into building a business as being an entrepreneur is difficult and bring lots of challenges. However, if that works for your personality and you have faith in your idea, it can be incredibly rewarding both financially and emotionally

It is critical that you do the cost / benefit analysis before you incur any of these debts. As there is a lot of uncertainty in valuing benefits of these investments, I would also recommend that you ensure there is a large safety cushion before you proceed with incurring what can be good debt.

This completes today’s post on Good vs. Bad Debt. The practical steps you can start taking from today’s post are:

• As part of your budgeting process, keep track of your debt(s): Make sure you know what debts you have and determine whether they are good or bad
• Prioritize repaying bad debt: Within your budget, allocate as much money as you can to pay off bad debt(s). A simple way of prioritizing is to choose the highest interest rate debts to pay off first
• When considering incurring any future debts, prioritize good debts: Where you have good opportunities to invest for the future with a high probability of stronger returns than the cost of the debt, be willing to borrow money for that investment. Make sure you do a cost / benefit analysis of that investment and ensure that you have a large safety cushion to prevent getting caught in a situation where lower than expected benefits can backfire on you
• Learn to say no to bad debts: When it comes to consumption purchases or items which depreciate in value, use the simple adage I quoted at the beginning of this post from my mother: “If you can’t afford something, don’t borrow money and buy it.”

Thank you again for joining me on my journey to build financial literacy for young adults and their families. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. If you have any questions on today’s post of if there are any topics you’re interested in my broaching in future posts, please let me know. I can be reached at [email protected].