Yesterday I revealed that in many cases any debt is bad debt.
The most common example is buying something disposable. Would you pay $30 for a $5 burger? Most people say no, but many people do this very thing! They buy the food with a high interest credit card and then they don’t pay off the debt immediately. Making minimum payments on the cards they may be paying for the burger over a long period of time.
The same thing happens with home mortgages.
My first home cost about $83,000. I purchased it in the mid 80’s with an interest rate of over 11%! Had I staying in that house until maturity of the loan I would have paid over $250,000! It’s the same as buying a burger, right?
OK, some would argue it’s not the same because the burger is gone and I can still sell the house. They say this is good debt because the house is an appreciating asset.
The last time I checked that home was still not worth $250,000. Had I stayed, never refinanced and the housing bubble not hit, I might have broken even after 30 years.
It doesn’t matter if the debt is to buy a house or finance a business. Good debt can never be defined solely by the type of purchase you make with borrowed money. The only thing that does matter is how much you of a return you can earn for the debt that you incurred.
Is there such a thing as good debt?
Technically, yes; but it is more rare than many think. For a debt to be a good debt three separate criteria must be met.
First, the debt must be used to purchase and then resell an appreciating asset. The resell can happen all at once, like when you sell a house after living in it for some time. The resell can also happen over a period of time, as with a rental property or in the case of financing a business. Sales of products or services over time generate revenue used to service the debt.
The second criteria is that your total revenue must be sufficient to pay for your investment plus any interest on the debt.
Lastly, there must be enough revenue to provide a profit on the total transaction. Breaking even is better than losing money but it’s not enough to consider going into debt as a good thing unless you can make a profit.
For a business, profit in excess of debt is transparent. Taking a look at your financial statements you either cover your debt and have retained earning s, or you don’t. At a personal level, this can be a little more difficult to determine.
Another debt often referred to as good debt is a student loan. But the reality is that not all student loans are good debt. I met a young man recently that claims to have over $100,000 in student loans but doesn’t make more than $35,000 per year. After years of education he chose not to pursue his childhood dream of becoming an attorney.
Housing can be murky too. As in my example above, even if I broke even selling my house after 30 years, I also would have enjoyed the benefit of a place to live in addition to some tax benefits. Was that really worth the $167,000 in interest? That all depends on the relative cost of rentals in the area.
photo by Rick McCharles