What’s the quickest way to start a heated debate among a room full of personal finance experts? I’m not certain, but starting a debate on the concept of good debt vs. bed debt must rank pretty highly on the list.
Opinions on the matter run the full gamut. Some people believe that debt is a tool to be utilized to finance a lifestyle – because #YOLO. Others would not borrow money for any reason whatsoever because debt is dumb and Dave Ramsey says so.
The trouble with such extremism, aside from being wildly unappealing, is the fact that a one-size-fits-all approach rarely works in life. The good debt vs. bad debt debate is no different.
What kind of debts are we discussing? What are the terms? What is the purpose behind the act of borrowing? Will the items or experiences being financed maintain value? What is the opportunity cost?
All of this is enough to make heads spin.
Traditional Stance on Good Debt vs. Bad Debt
Ask five of your closest friends whether they have any debt, and you’ll likely hear variations of the following:
“No, we’re not in debt. We just have a car payment, student loans, and our mortgage.”
“We have a few credit card balances – does that count?”
Answers like these can help us to begin to frame the issues surrounding good debt and bad debt.
Traditionally speaking, the average Baby Boomer defines good debt as money owed on an appreciating asset or an experience (i.e. education) which is likely to yield financial returns or benefits. Bad debt is defined as debt incurred on depreciating assets, i.e. does not yield positive cash flow.
Over time, however, these definitions have ridden the wave of cultural change. Today, in fact, some experts preach that all debt is bad.
Grandma and Grandpa may hold a traditional view on good and bad debt, but to their instant gratification seeking offspring, all bets are off. “If debt allows me to get what I want when I want it, it must be good!” they reason. This is a classic example of the leap-before-you-look mentality, and the eventual landing usually isn’t a pretty one.
Generational assumptions aside, we find ourselves at a tipping point in the Great Debt Debate. With any luck, the following may shed further light upon the issue.
Less About the Debt, More About the Debtor
Debt is a undoubtedly a complicated concept. Perhaps the only piece of the puzzle which is more complicated is the debtor himself.
When we borrow money, we make a statement about ourselves. We claim confidence in our ability to pay back our debts. This confidence can be fully justified or woefully misplaced.
Suppose for a moment that an uber-wealthy entrepreneur purchases a beach home on Lake Michigan and takes out a mortgage. Is this a good debt or bad debt? In this case, if she has the regular income and liquidity to pay off the mortgage in a relatively short period of time, we may safely consider this a healthy debt. After all, the home is likely to appreciate over time, and the mortgage provides additional flexibility to divert funds to other investments.
Let’s change a few pertinent facts in the above scenario for a moment. Suppose our entrepreneur is already upside down on her Chicago high-rise condo and is quickly burning through liquid cash like a raging wild fire due to a poor quarter for her business. We’re looking at a bad debt in this case, in all likelihood.
When evaluating debt, the circumstances of the debtor are everything.
So where does this leave us? What circumstances impact whether a debt is good or bad?
Years ago I purchased a 2008 Honda Accord from my grandparents. The vehicle was worth $17,000 at the time. I put down nearly half of the cost and financed the rest. We quickly paid the vehicle loan off, but even if we hadn’t done so, we were protected by built in equity. If at any time things went south, we could have sold the vehicle, paid off the remainder of our loan, and used the remaining cash to buy a beater car and buffer our emergency savings.
Equity is a fine mitigator of risk associated with debt.
2. Consistent discretionary income
When it comes down to the bottom line, the scariest thing about debt is the prospect that we might not be able to pay it off. As we’ve seen, equity is a great hedge against this possibility, but consistent discretionary income is even more valuable.
For the family who routinely spends all of its earnings, it doesn’t take much for what was once a manageable debt to become a significant problem. But for those who maintain sizable wiggle room on a monthly basis – say 5-10% of monthly take home pay – a healthy buffer can eliminate the stress of difficult periods which stretch the budget.
3. Liquidity (Cash is King)
Dave Ramsey begins every radio show with the reminder that “Debt is Dumb” and “Cash is King.” I feel the latter is correct, but the former requires modification. “Some Debt is Dumb” is more appropriate.
Again, assuming reasonable interest rates, debt becomes a problem when the debtor cannot meet his obligations. A healthy level of liquid cash acts as an additional line of defense. With cash in the bank, the debtor has options if debt obligations become cumbersome. He may sell the asset, rely on discretionary income to avoid touching liquid savings, or draw on his savings.
If you find yourself in debt or are considering entering into a debt relationship, consider the aforementioned factors to evaluate the situation. Generally speaking, based upon the established criteria above, the following are examples of good debt and bad debt.
1. Mortgage on primary residence
2. Home equity loan for home improvement purposes* (Depending upon interest rates, expected rate of return on the project, and existing equity)
1. Student loans
2. Auto loans
3. Revolving credit card balances
4. Cash advance and pay day loans
Readers, what is your position in the “good debt vs. bad debt” debate? How do you evaluate whether a debt is good or bad?