DISCLAIMER: I am not a financial advisor and this should not be taken to be financial advice. You should consult a financial professional for advice. I am a financial amateur. These are my thoughts and opinions on money that I have recorded here for my children, with the hope that my thoughts might help them. They are responsible for the results of the advice they choose to follow. Always worth keeping in mind: Past performance is no guarantee of future results. Your mileage may vary. The map is not the territory. Keep your eyes open. Smell it before you take a bite.
To my children:
I grew up thinking that all debt was bad. If you’re trying to make money, then why would you ever want to borrow money from someone else? But I’ve changed my mind. There is good debt and there is bad debt. Good debt is any debt that makes you money. Bad debt is any debt that loses you money.
An example of a good debt is taking out a student loan to become a doctor or a lawyer. After you become a doctor or a lawyer, your income will be higher than it could have been without your medical or law degree, and you can pay back the student loan with your income, and go on to make more money than you would have otherwise. Your overall long-term financial situation improves by taking out a loan to become a doctor or a lawyer.
Another example of a good debt is taking out a loan with 0% interest. I once bought a mattress for $2,000 and they were offering 0% interest rate on the loan for 4 years. I had the money and could have paid in cash all at once. But I’d rather pay slowly over time if it’s not going to cost me anything extra because then I can hold onto my money longer, invest it, and make some money before I pay off the mattress. I made payments every month but to keep the math simple, let’s say it was 4 yearly payments of $500 each. If I made one payment on the day I bought the mattress, then I have $500 that got to grow for 1 year before I had to pay it as the 2nd payment, $500 that got to grow for 2 years before I had to pay it as the 3rd payment, and $500 that got to grow for 3 years before I had to pay it as the 4th payment. I get to keep however much it grew before I make each $500 payment. If I invested it in a stock index fund that made 10% per year, then I would have an extra $320.50. ( = ($500 x 1.1 – $500) + ($500 x 1.1^2 – $500) + ($500 x 1.1^3 – $500) That’s more than a few free lunches. And they really seem free. Of course, the stock market isn’t a steady machine, but this is the idea.
As mentioned earlier, the interest rate on the loan doesn’t need to be 0% for this to make financial sense, it just needs to be lower than whatever investment you choose, so that you are making money. If you can borrow money at 2% per year and grow it at 5% per year under your care, then you are making 3% per year. It’s with money that’s not yours, so you have to be careful, and usually whoever loans you the money will put safeguards in place to ensure that you are careful, like asking for collateral to secure the loan.
An example of bad debt is credit card debt. If you don’t pay your whole credit card bill and carry a balance of debt over into the next month, then you will be charged something higher than 15% interest per year. It would only make sense to do this if you were investing in something that earned more than 15% per year. It doesn’t make sense if you’re just buying a TV. This debt is bad because it doesn’t help you make money. It causes you to lose more money than if you had not taken out the loan.
It’s not just the high interest rate that makes this type of debt bad, it’s what you do with the money. If you could borrow money at 15% per year and use it to make 20% per year, that would be fine. But if you borrow it at 15% per year to buy something that depreciates, then that is not going to improve your financial situation.
There is something to be said about the psychological effect of being in debt. You may not like it. Even if you know one day you’ll be a doctor or a lawyer and the debt was a good decision. This may be a reason to avoid debt for you. But it’s not a financial one. I try to replace that thought with a different thought. If I could have bought my house in cash and not taken out a home loan, that wouldn’t actually make me feel good, because by being debt-free, it means my money is being lazy. It’s just sitting in the house, not doing anything, when it could be out there making money, as long as what it’s invested in grows at a pace that outpaces the interest rate I pay on the loan. The house is appreciating, but it can do that with a home loan too.
The Bottom Line: Not all debt is bad. There is good debt and bad debt. Good debt makes you money. Bad debt loses you money.