Good Debt vs Bad Debt: Key Characteristics
Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time paying their bills either for lack of money or organization skills, most debt is likely to be problematic. For other people, taking on debt is less of an issue.
One of my followers was thinking of expanding his business and was concerned that taking on debt would be harmful. As part of helping him with his thinking, I identified general characteristics that distinguish good debt vs bad debt. He ended up selling his business instead of expanding it, but I am sharing my insights in this post. These characteristics may not apply to your particular situation, so be sure to think about them in the context of your own situation and temperament.
Characteristics of Bad Debt
Here are five characteristics of debts that I would consider bad.
You Don’t Understand the Terms
Loans and other sources of borrowing, such as credit cards, all have different terms. It is important that you understand the terms of your debt. For example, some loans, mortgages in particular, have adjustable rates. That is, the interest rate that you pay on your loan will change as a benchmark interest rate changes. If the benchmark interest rate increases, your loan payments will also increase.
Credit cards also can have interest rates that change. A teaser rate is an interest rate that applies to credit card debt for the first several months to a year. After that initial period, the interest rate charged on credit card debt can be very high.
Another example of a loan provision that can be problematic is a balloon payment. Some loans, including some mortgages in the US and many mortgages in Canada, have balloon payment provisions. For the initial period of time (often five years for Canadian mortgages), you make payments on your loan as if you were re-paying the loan over 30 years. However, at the end of the fifth year, the entire balance of the loan is due. The Canadian mortgage I reviewed requires the lender to re-finance the loan at the end of the fifth year, but at an interest rate that reflects the then-current interest rate environment and your then-current credit rating. In effect, that loan has an adjustable interest rate that depends not only on a benchmark interest rate but also changes in your credit score.
I consider any debt for which you don’t fully understand the terms, best avoided by reading the entirety of the loan document, as bad debt.
You Can’t Afford the Payments
When you enter into a loan agreement, you will be provided with the amount and timing of loan payments. With credit cards, the payments are usually due monthly and are a function of how much you charge and the card’s interest rate. Any debt that has payments that don’t fit in your budget is bad debt. I would even take it one step further and say that any debt that has payments so high that you aren’t able to save for emergencies, large purchases and retirement is bad debt.
High Interest Rate
Some types of debt, such as credit cards and payday loans, have very high interest rates. The definition of a high interest rate depends on the economic conditions. Currently (around 2020), I would say any interest rate of more than 8% to 10% is high. By comparison, when I was young in the early 1980s, the interest rate on a 10-year US Government bond was more than 15% and mortgage rates were even higher.
If you have debt with high interest rates, you will be better off re-paying them as quickly as possible as you can’t earn a high enough investment return on any excess savings to cover the interest cost. That is, the investment return you can earn on the money, especially after tax, is going to be less than the interest rate you pay on the debt. In that case, it doesn’t make financial sense to invest any excess cash but rather you will be better off by using any excess cash to pay off the debt.
In many cases, debt is used to purchase something large, such as a boat, a home or a car. When you make a large purchase, the item you bought is considered collateral and the lender can take the collateral if you don’t make your loan payments.
The value of some items goes down (depreciates) faster than the principal of the loan. If you default on your payments when that happens, the lender is allowed to make you pay the difference. Determining whether your purchase is something that will retain its value or will depreciate quickly is a good test of whether it is financially responsible to use debt to make the purchase. If not, I would consider the purchase a poor use of debt.
No Long-Term Benefit
Many other purchases for which debt, such as credit cards and payday loans, is used have no long-term benefit. For example, if you buy a knick-knack for your home with a credit card and don’t pay the balance when the credit card is due, you will be paying interest for something that has no long-term benefit to you. I consider using debt for items or experiences with no long-term benefit to be bad.
There is a gray area. If you use debt to buy clothes that are required for your job, the clothes themselves don’t have a long-term benefit, but they could be considered as creating the ability to go to work and earn money. As such, while I would normally consider clothes as a poor use of debt, I can see how work clothes that allow you to increase your income might need to be financed for a month or two on a credit card.
Characteristics of Good Debt (vs Bad Debt)
The first requirement of good debt is that it doesn’t have any of the characteristics of bad debt. That is, good debt:
- Has terms you fully understand.
- Fits in your budget, especially if your budget also includes saving for retirement, large purchases and an emergency fund.
- Is one that has a reasonable interest rate.
- Isn’t backed by depreciating collateral.
- Is used for something with long-term benefit.
There are many ways in which a debt can create a long-term benefit. I’ve mentioned buying clothes required for a job that allows you to earn money, in particular a lot more money than the cost of paying off the debt.
Your Primary Residence
Most people borrow, using a mortgage, to purchase a home. The market values of homes generally increase over long periods of time, though there are periods of times when the market values of homes decrease. In addition, there are a lot of carrying costs of owning a home, such as insurance, property taxes, maintenance and repairs. However, by owning a home, you don’t have to pay rent which, in theory, covers all of the costs of home ownership.
I think that buying a house is a good use of debt as long as the mortgage meets all of the criteria identified above. Although not specifically related to the use of debt, you might want to think carefully about buying a home (with or without debt) if you plan to live in it for only a short period of time. The transactions costs of buying and selling a home are high and you increase the likelihood that the value of the house will decrease if you own it for only a few years.
Using debt to buy a car is also quite common. If you are using the debt to cover the cost of your only mode of transportation and you need it to get to work, it can be a good use of debt. Again, you’ll want to check that it has the other characteristics of good debt identified above. Using debt to buy a car that is more expensive than you need or leads to loan payments that are higher than you can afford is not as good a use of debt.
Many people use student loans to pay for college. From an economic perspective, student loans can be either good or bad. The criteria for evaluating the student loans are:
- Will the increase in your wages will cover your loan payments?
- Will you earn enough after graduation to allow the loan payments to fit in your budget?
For example, let’s say you can earn $30,000 a year if you don’t go to college and $40,000 if you get a degree. If you borrowed $50,000 a year for four years at 5% with a 10-year term, your payments would be more than $25,000 per year.
Over the term of the loan, your increase in wages ($10,000 per year) is less than your loan payments. Over your working life time, the return on your investment in your student loans is about 3.5%. The return on investment is positive, so the use of debt could be justified using the first criterion.
It might be very difficult to cover the $25,000 of annual student loan payments on annual wages of $40,000 a year. If you are willing and able to live on $15,000 a year until your student loans are re-paid, they could be considered a good investment economically.
A smaller amount of debt or a larger increase in salary will improve the economic benefit of student loans. If you are considering student loans to finance your education, you’ll want to look at their economic costs and benefits carefully.
When you start your own business, you often need to invest in one or more of equipment, inventory or a place to run your business. Many people borrow money to make these initial investments. Starting a profitable business can be a very good use of debt, as it provides you the opportunity to increase your net worth. However, 30% of businesses fail in the first year and 50% fail in five years, according to the Small Business Administration, as reported by Investopedia. If you borrow money to start a small business and it fails, you will often still be liable for re-paying the debt, depending on whether you had to personally guarantee the loan or if the business was able to procure the loan.
There are at least a couple of ways you can use “debt” to invest.
Don’t Pre-Pay Your Debt
The most common way to use debt to invest is to invest extra money rather than using the money to pre-pay your mortgage or other debt. Whether it is good or bad to use this “debt” to increase your investing depends on several factors and your financial situation:
- The longer the term on your debt, the better the choice is to invest instead of pre-paying your debt. If your loan payments only extend over a year or two, it is more likely that your investments will lose money making you worse off than if you pre-paid your loan. Over long periods of time, your investment returns are more likely to be positive.
- The lower the interest rate on your debt, the better the choice it is to invest instead of pre-pay your debt. If the interest rate on your debt is higher than you can expect to earn on the investments you would buy (after considering income taxes), you will almost always be better off pre-paying your loan. If your interest rate is low, e.g., less than 3% or 4%, you are more likely to earn more in investment returns than the interest cost on your debt.
- You have another source of income to make your loan payments if your investments decrease in value. For example, if you were planning to retire in the next few years, pre-paying your debt is more likely to be a better decision than investing. On the other hand, if you plan to have other sources of income besides your investments for the next 10 or more years, you might be better off investing rather than pre-paying your debt.
Investing on Margin
Another way you can use debt to invest is to buy your investments on margin. Under this approach, you borrow money from the brokerage (or similar) firm to buy your investments using your existing invested assets as collateral. In many cases, you can borrow up to 50% of the value of your existing assets. So, if you have $100,000 of stocks, you could borrow $50,000 to make additional investments.
The drawback of buying investments on margin is that the lender can make you re-pay the loan or a portion of it as soon as the value of the assets you own (the $100,000 of stocks in my example) decreases to less than twice the amount you’ve borrowed. Unfortunately, the amount you borrowed may have decreased in value at the same time while the amount you borrowed as stayed constant. As such, buying investments on margin is considered very risky and should be done only by people who fully understand all of its ramifications.
Final Thoughts on Good Debt vs. Bad Debt
Debt, when used carefully, can greatly improve your life and your ability to earn money. However, if you take on too much bad debt, it can lead to significant financial problems. This post has provided a framework to help you decide whether any debts you have or are considering are likely to be good debt vs bad debt.