Posted by Robert on August 15, 2011
Some commentators on personal finance like to repeat that there’s good debt and bad debt. They talk as though the nature of the debt itself changes, which is nonsense. Debt is debt, and adding good debt or bad debt to a decisions doesn’t make it a good decision or a bad decision. Debt is a magnifier, used to leverage resources. Debt will magnify the outcomes of good decisions and bad decisions equally.
If the outcome of a decision progressed in a straight line (eg. getting consistently better and better or worse and worse), it would be simple to act in ways that produce good outcomes. But that’s not normally the case, and our fortunes often bounce around, going from better to worse and back. When debt is used to magnify the outcomes, this cycle might produce ruin in an storm that otherwise could be waited out.
As an example, let’s consider a person who buys a car. They have a steady job with a healthy paycheque, but they have no savings. They are faced with two choices: save for the car from each paycheque or buy a car using a loan. Suppose they choose to save $500 per month for a year, or they can get a bank loan that will charge $500 + $25 interest per month for a year. The interest cost makes the loan a less efficient choice, but the car can be enjoyed now, not one year in the future. The problem comes if the employer has a problem with their salary payments and is a week late with a single paycheque. In the “saving” scenario, the employee can dip into their savings, postpone a deposit to the car account, and continue successfully. In the “loan” scenario, a single missed payment might cause the bank to repossess the car, causing the money already paid to be lost.
The risk of borrowed money exists regardless of the purpose of the loan. Whenever a loan is arranged, the risk of default should be protected against by having the ability to make payments (or complete repayment) if other sources of income fail. If a person is satisfied that they are suitably protected against the risks of a loan, they can decide whether or not the purpose of the loan justifies the cost.
The problem, it always seems like a good idea at the time (or no one would ever take on debt). I don’t think it’s always easy to identify good debt, however. I recommend starting from the assumption that debt is always bad. From there, debt may be acceptable if it is an investment in producing future income in excess of the interest cost. As an example, buying a business using debt could make sense. The income from the business should pay the investor’s salary, the interest on the debt and a little profit. Buying a car could be good debt, if it makes it possible to get a job with a generous salary. Buying a more expensive car than necessary mixes bad debt with good debt. Buying a house isn’t really good debt except that it avoids losing money by paying rent; it still doesn’t make sense to buy more house than necessary.
When do you think student loans good or bad debt? Have you had other debt that you consider “good” or “bad”?
This post is now part of the #323 Carnival of Personal Finance.