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Sunday, April 23, 2017

Is there such a thing as good debt?

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.

Comments

16 Responses to “Is there such a thing as good debt?”
  1. SavingMentor says:

    This is an interesting point and I think I agree with you. It more comes down to good debt choices and bad debt choices. Obviously lower interest rates can make debt more palatable and likely to be “good” but it is still costing you money unless you make a decision to use it effectively.

  2. Robert says:

    Lower interest rates make debt more affordable, but also more dangerous, because the possibility of rates rising is greater from a low starting point. Higher interest rates could make a loan unaffordable. Besides that, some loans are “callable”, meaning the lender can call for repayment at any time.

    Remember than debt service payments are owed before any other spending decisions are made, which goes squarely against the idea of “paying yourself first.”

  3. I don’t believe in “good” debt. I feel there is debt and worse debt.

  4. Theo says:

    What if you need a car to get to work, have not a lot of savings, and your old car just broke down beyond repair. Your carloan can become kind of an investment to grow your wealth and the risk/reward picture might change in favour of taking a loan.
    How about a student loan to increas your future salary
    eg get some skills.
    How about a mortgage you can afford,
    by the time you save for a house the houseprice increases and you pay rent to a landlord.
    Lots of examples of good loans

  5. Robert says:

    Theo, you borrowed my examples, but you didn’t answer the question. Are student loans ALWAYS good debt? How can you tell that a mortgage is affordable? Does owning a house incur costs that renting doesn’t?

  6. Dilbert says:

    I think by many people’s definition of good vs bad debt, good debt is a tool that will allow you to make more money in the future. However, like your car loan example, there’s a gigantic gray area between want and need. Cars also compound the issue where they will decline in value on their own.

    I also love the idea that people renting are throwing away $1000 a month, but paying $1000+ a month in mortgage interest alone is ok, because it’s good debt…

  7. George says:

    Magnitude of the reward vs. the risk is the consideration. Putting a realistic value on the reward is the hard part for most people and why many say “there is no good debt”.

    However, if there were no such thing as good debt, then businesses wouldn’t prosper. So obviously a case can be made that good debt exists.

  8. I’ve always called student loans and mortgages a necessary evil. Saving up for either of these is futile. With house prices and the cost of education sky rocketing, you would be left in the dust and no further ahead by saving do either.

    You have to step back and look at debt from another perspective. Yes consumer debt is for fools. Carrying a balance for a big screen tv is quite possibly the most moronic thing a person can do financially. Cars are a waste of money, but I need one for my proffe

  9. Stupid smart phones…

    Profession. The idea is to buy a reliable car, not the most expensive one. Save up to pay cash or a very good downpayment for a quality vehicle that won’t leave you stranded.

    Debt is a fact of life, you just have to be smart about it.

  10. Robert says:

    George, I agree that the value of using debt is the cost vs. benefit. Being essentially optimistic creatures, however, I worry that we overestimate future returns and underestimate the risks of debt.

    As an example, if I were to buy a business that produced a 15% return on investment, with current interest rates around 5%, would I be 10% ahead each year? Maybe, but what if costs increase, revenues drop or interest rates rise? Not being able to answer those questions is what makes the risk vs. reward balance difficult to find.

  11. Gars says:

    There is good debt, but debt free is best.

    I borrowed for an education; I borrowed for an office building; I borrowed for a house.

    Everything else I pay cash for. If you can’t pay cash for it you haven’t yet earned it!

    Drive a reliable old car. Learn a lifestyle that’s frugal and you’ll be debt free sooner than you can believe.

    There is bad education debt. You’re investing in yourself. You’re making your services more valuable. I can justify spending $35,000 on a dental diploma (1984) because the potential to repay that debt and significantly earn more than with a lesser degree is realistic.

    Now look at a Harvard BA degree to teach elementary school. That’s not realistic when you can get a similar degree from a state school for a lot less.

  12. John The Contractor says:

    Wasn’t it Rich Dad, Poor Dad who defined good debt as debt that allows you to purchase an asset that puts money into your pocket ( rent, dividend, interest, etc.), whereas bad debt is defined as debt for a depreciating asset, (cars,electronics, recreational vehicles, etc.)?

  13. deegee says:

    For me, student loans and my mortgage were good debt. As others have posted already, without my student loans I would not have been able to graduate from a good-enough college to get the job I wanted and repay the loans. Thanks to scholarships which paid for 1/3 of the tuition+room-&-board (with my parents and I splitting the rest), and various savings I had and a small inheritance from my grandmother who passed away just before I started college, I owed only $3,000 when it came time to make monthly payments.

    As for a mortgage, on an after-tax basis my mortgage+co-op apartment maintenance was about the same as rent, with the added benefit of building up equity instead of flushing rent down the drain. Once I paid off that loan, my housing expenses halved compared to rent I would have paid, and I have an actual asset while the maintenance is still mostly tax-deductible versus rent which is not.

    I always made sure to never have more than one of those big debts at the same time – I paid off the student loans before I took on the mortgage. I always paid cash for my cars, too, avoiding costly car loan interest as I already had a student loan OR a mortgage (but never both at once). I am barely on my third car in the 25 years I have owned cars, so they last a while.

    And, of course, I never had any credit card debt, having always paid off those bills in full every month. Most months I don’t even use the card.

  14. Kaye says:

    The only debt my husband and I have had in thirty years of marriage is a mortgage (paid off early) which I call good debt since we avoided paying rent, used it as a tax deduction and now live in it free except for property taxes and maintenance.

    We drive older cars that we paid cash for and drive them longer than most people would (my Toyota Camry is 10 years old). We put those monthly savings into investments and we both retired early. That would not have been possible if we had not avoided “bad debt” such as credit cards and even interest on auto loans and been cautious with our money.

  15. One other way to look @ student debt is not whether it is good or bad – but is it simply an investment?

  16. Robert says:

    SustainablePF, you could certainly ask that question. But since the payoff is so unpredictable, is it really possible to consider an education as an investment? Job training should definitely be looked at as an investment. But education, if you’ll excuse me waxing philosophical, is a capacity for learning and critical thinking. That will benefit every aspect of your life, and it may or may not happen in a school.

    Setting aside my hesitance to apply a cold calculation to human beings, developing your own capacity is often a worthwhile investment.

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