Being ‘in debt’ is broadly portrayed as a negative situation, however, the right type of debt can be acceptable, agreeable, or even an amazing tool for financial growth. I’ve had all types in the past and this is my take on broad categories, what to look out for, and how to talk about them generally. If you’re already in a tough debt situation, take a look at a non-profit organization like NFCC or the Citizens Advice Bureau.
1. Good debt - Works for you:
There is a Chinese proverb ‘Big ships often sails on big debts’. Good debt (often called ‘Leverage’) is borrowing money to directly increase the return you will make on investment since you can earn a return on the total amount, including the borrowed money, rather than just what you can invest yourself. Leverage is everywhere in the business world and the debt is positively considered ‘raised’ rather than incurred - this is a valuable concept.
Example:
A kid starts a neighborhood stand selling apples to people who walk by using $10 allowance.
The wholesale cost of an apple = 50c
Sale value on their stand = $1
$10 buys 20 apples which can be sold for $20, profiting $10. The first situation in the image below.
Now instead imagine the kid borrowed $90 at a 5% interest rate from their parents. $90 + the original $10 = $100, they can buy 200 apples selling them for $200. You pay back the $90 + $4.5 interest ($200 - $104.5) and profit $95.5 with the same $10!!!
The above is a simplification but provided you are confident the return will cover the cost of the loan the opportunities are pretty endless with leverage. Leverage is how companies often fund an acquisition or large expansion - read about Tesla’s recent debt raise in China here.
Remember, interest payments are certain and returns are not, so use with caution.
2. Bad debt - Spending beyond our means -
It’s generally bad to borrow money to pay for things which will be consumed or decrease in value over time. Most household expenditure fits into this category including Christmas gifts, groceries, rent, car, travel, clothing, electronics, unexpected costs etc. Paying for anything which isn’t going to improve your financial position with borrowed money will, at best, increase the cost (cost of goods + interest) and at worst leave someone straddled with a growing debt to pay back.
Avoiding this type of debt can involve difficult trade-offs and sacrifices and paying off all of this debt as a top priority is imperative to get on a path to growing wealth. There are great communities on Reddit like FIRE which can help to be frugal be more enjoyable.
Examples:
Payday loans - The worst of the worst. The average APR is ~400% and with roll-overs and fees anyone in a tough enough situation to need one will be quickly gouged by repayments or trapped forever by the compounding debt. Never use these ever.
Credit cards - The average APR for credit cards in the US is ~15% and they often default to minimum payment - which will result in barely paying the previous month’s interest. $1,000 will take ~5 years and almost an additional $400 to clear at 15% APR paying the minimum payment. Only use Credit cards for the benefits and always pay in full.
New cars - Auto loans are the third-largest household debt and average at 4.2% APR. Cars are a depreciating asset, they are worthless over time, and a liability given the owner’s responsibility costs e.g maintenance, insurance, tax etc. Always buy used and pay cash.
3. The messy middle - Investing in the future can be good:
I think of ‘acceptable’ Debt as borrowed money to invest in something which should improve your financial situation over time, albeit in-directly. This is a little more subjective than the direct benefits of leverage and requires self-discipline, but if it isn’t directly attributable like 1 or negatively impacting your situation like 2, then it probably lives here.
Examples:
Buying a house - Mortgages make up the largest part of household debt (around 2/3). With house prices averaging a ~5% appreciation annually over the last 15 years but slowing down recently, it’s less likely the value (equity) increase on a property will significantly outperform the interest costs on a mortgage (especially when coupled with the purchasing costs, tax, maintenance, and inflation). That being said, it’s justifiable debt given you’re going to be offsetting rent you’d be paying someone else, provided the property will retain its value. You can use the property as collateral to raise good debt in the future and can also pass it on when that time comes. Think of it more like saving than making money.
Education to increase earning potential - Student loans are the second-largest household debt type after a mortgage, are rising rapidly as a percentage, and take an average 20 years to pay off. Taking on debt to pay for your education is only justifiable if the qualification is going to increase your future earning potential. It is common for Europeans to take a ‘gap-year’ before starting a degree allowing more time to weigh this huge decision.
Vehicle to get to work - We’ve already talked about why auto loans are bad. Taking on debt to pay for a vehicle is only really justifiable if it’s for work e.g you need it for work or to get to a job which can’t be accessed by public transport. Even still, buy used and with affordable repayments.
So this is what I’ve learned about debt over the last few years. The right type of debt can be a useful tool to accelerate investment returns or improve your future prospects, and the wrong kind can scupper any chance of building wealth.