Good Debt vs. Bad Debt

If I had a dollar for every differing opinion on this topic, I would be retired, folks. This may be the most misunderstood and controversial topic for discussion among the finance gurus, and to be honest I think a lot of them have it wrong, and it hurts people. Let me explain:

First of all, I don’t like the terms “good” and “bad” debt, because not all “good” debt is good, and not all “bad” debt is bad. For this discussion, I will use the terms “debt” for what many think of as “bad debt” and “leverage” for what most refer to as “good” debt. Put simply, leverage is borrowing money to make money, and debt is borrowing money to spend it. “Bad” debt (aka debt on non-appreciating assets) is effectively the debt you incur to buy something that you can’t afford. Whether it’s a purse or a boat, if you don’t have the money, the debt you incur to have it is “bad,” meaning, it is highly unlikely to benefit you financially. ALL of the balances you’re carrying on your credit cards are debt. Most car loans fall into this category. Most payment plans are debt. I think it’s important to minimize, and in most cases eliminate, this kind of debt to improve your financial freedom- but there are times where it’s actually beneficial, so writing it off completely as a negative is a mistake.

Leverage, or “good” debt is money borrowed to purchase appreciating assets, like houses. Leverage allows you to use financing to improve your financial situation, either today or in the future, by using someone else’s money to acquire something that will (or should) give you a positive return on investment down the road.

But the difference between debt and leverage is not so much what it’s used to buy, but WHY.

Let’s look at the most common source of large debt- houses. Most home mortgages are considered a form of leverage. Many people, especially young people, don’t have $250K or more lying around to buy a house with cash, so we use a long-term loan from a bank to finance this large purchase. Although data is conflicting, home prices for the most part beat inflation by a narrow margin- in my opinion, it’s not the best investment strategy, on its own. However, considering that you need to live somewhere, when we combine the investment in a home with negating rent payments, it’s a mild win (in most cases). I’LL DISCUSS THIS MORE IN A SEPARATE POST. Mortgage rates have been low for the past few years, which makes this investment more appealing. At the end of the day, if you use a loan to purchase a house, you will likely end up in a net-positive financial position by the end of that transaction, whether you pay off the loan, or sell the house. NOW- obviously there are exceptions, and major market events, buying more house than you can afford, and other factors can and do tip the scales on this. I’m focusing on the by-and-large typical expectation here, all exceptions notwithstanding.

Many financial gurus focus on paying down home loans to reduce “debt.” I tend to disagree with this advice. For individuals who are entirely incapable of managing their own finances, saving money at all, or investing– paying down all debt, regardless of “type,” is the best strategy. But most finance-curious readers are a savvy enough to capitalize on the advantages that come with utilizing some leverage- and frankly, that’s what rich people do- they use other people’s money to put more money in their own bank accounts. We’re aiming for THIS category.

What does this mean? Here’s an example. I purchased my last home for $275,000 almost seven years ago. This was my second home, so I had the opportunity to save for the down payment and I financed $220,000 via a conventional 30-year mortgage. My mortgage payment is $1003 per month, and I still owe about $190K on my loan. There are several options here for how to handle this situation- I could put all extra money toward that loan to pay it off sooner (maybe years sooner!). At first glance, this may sound like a great idea, but for me it’s not. That is because I divert all of my additional income to a long-term brokerage investment account, and my returns on those investments should be 8% over the long-term. My interest rate on my mortgage is 3.625%, and I earn 8% on my investments, so my investments are returning 4.3% more than my mortgage. I would prefer to carry the mortgage and effectively get twice the bang for my buck by investing it- wouldn’t you?

There is another angle from which to look at this scenario. Let’s say I do pay down the mortgage. If I wanted to pay it off completely in 10 years (instead of the 23 years remaining on the loan), I would need to pay an extra $833 per month. Ten years from now, I would own that house free-and-clear, and would have saved myself $55K in interest. This sounds like a win, no? Well, we first have to consider the opportunity cost of this decision- what am I giving up to make that happen?

If I had $833 per month to do SOMETHING with, and I opted to invest it every month instead of paying down the mortgage, I would have a whopping $152K after ten years- leaving me almost a full $100,000 ahead of the mortgage payoff scenario. After 10 years, I would still have the $1000/month obligation (if I even still own it by then), and $150K in the bank that I wouldn’t otherwise have. It would be challenging for me to make an argument for the payoff plan, unless there were a pressing reason to eliminate that payment obligation, like reducing monthly bills for impending retirement. Considering that time is the most VALUABLE component of wealth building, I will opt for the opportunity to put money to work NOW instead of later almost every time.

The third scenario is that I have an additional $833 per month, and I decide to use that to make payments on an Escalade (or whatever the “thing I have to have” at the moment) instead of paying down the mortgage OR investing. In this case, at the end of 10 years, I’m out the $55K in interest I could have saved, I have $0 extra in my bank account, and I own a vehicle that is worth a few thousand dollars at best. THIS is the scenario that is tough for a lot of people. I overcome this by doing the math before I obligate myself to a purchase, and usually the lure of $100K (or whatever it works out to be) is enough to keep me in line. Listen, we’re all human. This isn’t about making perfect decisions all the time- just try to do your best and live your life, ya know? At least knowing how to solve the equation helps, especially over shooting from the hip on major decisions.

I use a similar model to evaluate auto financing. I have the option to purchase a car with cash, or I can finance it for 5 years at 3% interest. I like to keep my cars for 5 years or more, and keeping the money invested instead of using it to buy the car yields a 5% advantage- at the end of the loan term, my invested cash earned me far more than the interest I paid on my loan. For me, and for many, the opportunity cost of financing to keep growing assets in action pays off. This example is using an auto loan as leverage. When is an auto loan “bad” debt? When you use it to buy something you cannot or should not afford. It’s not leverage unless you are using it to invest money or keep money invested. Never use financing to afford something that is out of reach- it’s not worth it. If it’s unattainable right now, choose something less expensive, and make good choices in the meantime.

What about business debt? I know a guy who makes these amazing barbeque sauces, and regularly competes in barbeque competitions with his cooking. He needs to buy grills and smokers and raw materials for his cooking. I know a farmer who has to buy equipment for planting and harvesting crops. When is it okay to borrow?

You have to really be honest with yourself about WHY you want to make the purchase, even if you don’t have the money to do it right now. How is it going to pay off? Do you even know how it is going to pay off? If you can spend $100K in farm equipment and that allows you to farm additional acres of land, yielding higher crop sales, next year and every year after that for the 10-year lifespan of the equipment at say, an additional $10K per year, I would really second guess if this leverage will pay off- it’s dangerously close to a break-even, with a lot of risk. But if you’re looking at $20K per year in increased profit, it might be a great investment. Try to avoid the temptation to use your business as an excuse to purchase things you want, but don’t need. I struggle with these choices regularly.

Every buy decision is a math equation, and financing is a second equation. In every case we are solving for a variable that is usually a future dollar amount. Sometimes it’s a bit subjective, but generally the math will speak for itself. In business, it’s an equation solving for increased expenditure vs increased profits. For your personal finances, a cash vs. finance problem is an equation solved by future values of where your money works hardest for you.

Learning to use leverage to maximize your investments and savings is a solid strategy, and you can participate with great results, even if you’re new at this. But debt is one of the leading causes of strife of our time, so learning to exercise good discipline around borrowing is imperative. In summary, debt makes us poor, and leverage can help you become wealthy. Pick your poison carefully.