Good Debt, Bad Debt... On Occassion...

Fixer Upper

Fixer Upper

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.

This article was featured in the Carnival of Debt Reduction hosted by Canadian Finance Blog. Please check out this carnival for many other great articles about personal finance.

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.

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photo by Rick McCharles

13 comments to Good Debt, Bad Debt… Continued…

  • You are right about this, Coach! I have waded through all kinds of debt and since debt is always a negative, it is rarely a good thing. Interest is the worst part and the phrase, “oh don’t worry about it, it’s a write off” is just another way we convince ourselves that it’s okay to spend money we don’t have for things we may not even need. You mention the $30 hamburger, I recently learned about the popularity of “gourmet grilled cheese” and was flabbergasted (and impressed) with the notion that you could sell something right off the former kids menu for such a high price, just by adding fancy mushrooms. Even a die hard foodie like me can see through this one. Debt free is good!
    .-= Tracy´s last blog ..Key to Success: Overcoming Learned Helplessness =-.

  • Excellent point, and I didn’t realize the historical return on real estate investments was so low. Who in their right mind would knowingly invest in something that only returned .4%? I’ve talked to a lot of people about good debt vs. bad debt, but conveniently left out the part about when “good” debt goes bad, like when a student takes a loan for his tuition and then can’t find a good paying job.
    .-= David @ MBA briefs´s last blog ..Ready to start your own business? =-.

  • The LeanLifeCoach

    @Tracy – Debt free is definitely the way! With routine travel, I eat out often. I understand companies have to make a profit but in some cases it’s disgusting to think about how much extra we pay for the the service.

    @David – I was surprised as well. Goes to show the real impact of inflation. That and we tend to forget old bad news, the memories of double digit equity increases in the past several years have lulled us into believing this has always been! The chart on yesterdays post speaks volumes! (Inflation Adjust Home Prices)

  • From where I’m standing I only really consider businesses or real estate to be the only good debt candidates. Even then 100% financing doesn’t really seem to fit good debt either…

    Student loans seem a bit off the mark considering over half of college grads end up doing something completely unrelated to their field of study anyways. It’s more an investment in being socially normal for career grooming. Just my 2 cents.
    .-= Ryan @ Planting Dollars´s last blog ..An Interview With Neal From Wealth Pilgrim =-.

  • I am not an advocate for going into debt, and I intentionally left the subject of “Good Debt” out of my book “Defeating Debt.” There is such a thing as good debt, but it is only when someone else pays it. Good debt is not taking on debt to purchase an asset you assume will appreciate. Good debt is taking on debt to make that will create immediate cash flow whether the asset appreciates or not. It is a sticky subject and one most people should just avoid all together. The reason I left the topic out of my book is because my book is written about personal finance and money management, not building wealth. Any personal debt is bad debt, but the wealthiest individuals throughout history have learned the difference between good debt and bad debt, and how to make good debt work for them. You make some great points though.
    .-= Chris´s last blog ..Would I Read a Book by Tiger Woods Now? =-.

  • LeanLifeCoach

    Ryan – As usual, you have a great command of the written word. “Debt Candidates” There are times that debt can be leveraged for gain but I can’t help but wonder how often it really happens.

    I’ve been using some of MBAbriefs stock picking info to look at some public companies. It seems many just have a revolving door of debts. It makes you wonder how often manipulation of the numbers covers how inefficient debt can really be?
    .-= LeanLifeCoach´s last blog ..Finance & Marriage – To Share Or Not To Share? =-.

    @Chris – Thanks for dropping by. You bring up a good point about debt. If someone else is paying for it, how bad can it be? With most businesses failing in 5 years it can’t still be all good, but if your are going to have debt, getting someone else to pay for it is certainly the way to go!

  • Ya gotta stop with the compliments Greg! If you wanna see good writing check out this girl’s blog… Awesome writing ability! http://www.kellydiels.com/

    As for your son just have him read my blog a lot and I’m sure he’ll be fine 😉 What does he say he wants to be when he grows up?
    .-= Ryan @ Planting Dollars´s last blog ..An Interview With Neal From Wealth Pilgrim =-.

  • $167,000 in interest over 30 years means an average of $5,567 per year. I suppose it’s not a bad thing compared to the average rental cost over the years. You raised a valid point by saying that housing is not always a good debt because everyone is under the impression that the house price’s increase will exceed the inflation and interest rate. But then again you’re not supposed to buy your residential house for the sole purpose of making money.

    I agree with your point about student debt being a dud sometimes. It’s scary how most young professionals will spend up to first 10 years of their working lives to pay off that debt. I’m blessed to have my parents paid the whole thing. Hopefully my kids will be as genius as Bill Gates, drop out of college and make billion of dollars 😀
    .-= Bytta @151 Days Off´s last blog ..Day 11: Designing Your Life with Savings Snowball =-.

  • The LeanLifeCoach

    @Ryan – kellydiels – I took a quick peek, thanks for the tip!

    @bytta – With respect, I disagree. You are right, of course but I disagree. There are lots of people with different opinions but most I have ever heard suggest buying a house “because it’s the best investment you could ever make”, “you get the tax write-off”, “you won’t be throwing your money away” etc. I’m not saying don’t buy a house, but I am saying in the vast majority of cases debt sucks! The more I think about it the more I wonder if we should do like our grandparents did; save first and then buy.

  • Ah, I understand where you’re coming from. Most people who dole out those suggestions are:
    1. Well-meaning older members of family who proved it was true because housing was dirt cheap during their time.
    2. Real estate sales agents who pry on your money.

    Still, for me, getting into debt to buy a house is not inherently bad. It is when you OVER-LEVERAGE yourself, the drama happens. Ideally people should only borrow up to 3 times their annual income, but these days it is common to borrow more than 5 times their annual income; I have a friend who borrowed 8 times her annual income and I’m scared for her(gorgeous house, though :)).
    For our household, the initial mortgage is about 1.5 times our annual incomes and we’re almost half-way through (my friend would never live in a house like mine). I guess it depends on how you play the game and what you are willing to sacrifice .
    .-= Bytta @151 Days Off´s last blog ..Day 11: Designing Your Life with Savings Snowball =-.

  • The LeanLifeCoach

    @ Bytta – 8 times! ouch!

    I’m with you. When we bought our current house, we could “afford” over twice as much. My wife was ready to go all the way but I held back. As a result we will have our note paid off in 12 years at most and hopefully sooner.

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