In the past I have come across as pretty anti debt. I chronicled our struggle with over $140k of student loans. I explained the secret to getting out of debt was to passionately hate debt because of how it robs your future. The article how it feels to be debt free describes the wondrous freedom of eliminating the burden of debt. I even advise against student loans if the ROI is not high enough.
However, let’s take a step back. Could it be that not all types of debt are bad? Is there any possible way taking out a loan could actually increase your wealth? The answer, perhaps somewhat surprisingly, is a most definite: yes.
The Concept of Leverage and How it Can Make Debt a Good Proposition
To understand how debt can potentially be a good, shall I say great, thing then one must understand what leverage means. Simply put, when it comes to borrowing, leverage means you take the loan proceeds and use the money to perform an activity which will make you more money than you owe for the loan.
For example, you are able to obtain a loan for $100 with a 5% interest that is due in one year. That means in one year you must pay back $105 which consists of the principal ($100) and all of the interest ($100 x 5% = $5).
Upon receipt of the loan funds, you buy the Super Duper Deluxe Head Freeze Snow Cone machine. You concoct an almost hypnotic array of snow cone flavors and your cones become the new rage. The sales start pouring in and by the end of the year you have earned a mind boggling $200.
After paying back the $105 amount due on the loan, you now have $95 of cash left over in your syrupy stained, sticky hands.
That’s leverage. And that is how debt can be good. But, there is a catch.
The Downside of Using Leveraged Debt
Leveraging with debt is extremely risky. If you are not careful, you could lose the shirt off your back and then some.
Taking the previous example, let’s say your business plan was not actually all it was cracked up to be. In your absentmindedness, you launch your snow cone business in the heart of a cold, snowy winter and no one is remotely interested. Your entrepreneurial efforts “melt” away and the business is a flop. You only manage to earn $10 because your mom took pity on you and bought a few snow cones.
Yikes. Now you still owe the $105 and you only have $10 of lonely dollar bills at your disposable. How will you cover the other $95? That amount does not sound like much money, but when larger sums are borrowed the stakes are much higher.
Types of Good Debt
The following are potentially good types of debt. Remember, any debt can be bad debt if taken out in the wrong circumstances or with unfavorable loan terms. Nonetheless, certain types of debt, if leveraged properly, can make you better off in the long run.
- Business Loans – If you are already a small business owner or have dreams of launching a new enterprise, then taking on debt to fund the business could be a godsend. Many small businesses seek out Small Business Administration (SBA) loans which are partially guaranteed by the government (to protect the lender in case of default, not the borrower). Lines of credit or conventional business loans from banks are also ways to capitalize on “good debt” by leveraging the borrowed money to turn a profit. If a small business owner can borrow at say a 5% interest rate and then use that money to earn 10% profit then I would classify that as good debt. Once again, there is a high degree of risk involved. Many small businesses fail. The debt itself can be a powerful tool if leveraged successfully.
Oh, and large corporations do this too. They borrow money all the time particularly through issuance of bonds. It is the same concept though – borrow at a certain rate and use the money to earn money at an even higher rate of return.
- Property Mortgages – Part of the American Dream is to own a house and the vast majority of homeowners finance the purchase of their home through a mortgage. This is also leverage because the value of the property can increase over time. If you borrow $80,000 at 4% on a $100,000 purchase and sell several years later at $125,000 – that’s leverage! That is good debt.
Taking out mortgage debt for rental properties also falls under the good debt category. The debt can be leveraged through both price appreciation and rental income.
- Student Loan Debt – The use of student loans to fund your education can be a superb way to leverage. Incurring debt while still in school may seem worrisome since you are not able to start earning right away. Obviously, the leveraging of student loan debt is not immediate. Once you graduate and embark on your career, the financial return will start to manifest. Keep in mind – you owe it to yourself to ensure the ROI on your student loans is worthwhile.
Types of Bad Debt
These types of debt are almost always bad. They provide little opportunity for leverage.
- Car loans – Auto loans might be a necessary evil. After all, you need to get from place to place somehow and public transportation or riding a bike is not always feasible. One could also argue there is some quasi type of leverage involved with a car loan since you use the vehicle to commute to work which allows you to earn your income. The reason why I classify car loans as bad debt is because cars are not an appreciable asset. They also do not directly earn you money (unless you drive for Uber). Finally, most people buy “too much” car. That is, they spend extraneously on upgrades when they truly could be getting by on a smaller, more barebones car. If you cannot pay all cash for a car then an auto loan is one type of bad debt you might have to just deal with.
- Personal Loans – Taking on unsecured personal loans, which you usually can get approved for based on acceptable credit scores, are most always bad debt as well. That is because these types of debt are generally used to pay for personal expenses of some kind. Off the top of my head, about the only situation where you might be able to improve your financial situation with a personal loan would be if the interest rate was low enough to allow you to pay off higher interest rate credit card debt. Your best bet is to stay clear of personal loans. They could easily damage your credit if you cannot make timely payments and the interest rate will be fairly high.
- Credit Card Debt – The use of credit cards can be highly beneficial if done properly. However, credit card debt – carrying balances each month and paying interest – is extremely bad debt. The non-introductory interest rates are outrageous and, as with personal loans, credit card purchases are usually spent on consumer related spending. Rare is the occasion where credit card debt makes someone better off financially.
Good Debt vs. Bad Debt
A helpful guideline when determining if debt is either good or bad is:
If you use the loans to produce, then there is potential for great pay off. That is good debt. On the other hand, if the loans are to be used to consume, that is bad debt and it can and likely will plunge you deeper into financial slavery.
What are your thoughts on good debt vs bad debt? How much does the riskiness of leverage deter or encourage you to incur debt? Can you think of any other types of good debt or bad debt?
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