Debt: The Good, the Bad, and the "Meh" - A Borrower's Guide

Debt is one of the most polarizing subjects in the finance world. The anti-debt crowd believes you can’t become wealthy with debt, while others believe you can’t become wealthy without it.

I believe debt is all about financial literacy and using that knowledge to manage the debt. Proper debt management means you are not taking on too much and you are careful to not take on the wrong kinds of debt.

Understanding Debt

Debt is all about leverage. Simply put, you use debt to your benefit. The mistake is when debt is taken as a bail out to “relieve” financial pressure and someone puts themselves in a position where the amounts or terms of the debt don’t allow them to progress economically.

Debt can go into 3 categories: Good, Reasonable, and Bad.

Let’s break down the characteristics of these categories.

The Good

Interest Rate: Low interest relative to the average rates at the time the loan was issued. Interest rates are viewed as a penalty. The proper way to view them is the “cost of financing”. The point is to make sure the cost of financing doesn’t outweigh the benefit of financing.

Life of Asset: The economic benefit of the asset is much longer than the length of the loan. A car loan on 3 year financing is considered good debt due to the life of the vehicle being much longer than 3 years. Consumers are keeping their cars for an average of over 10 years!

A 3 year loan on a vehicle you own for 10 years gives you much time to enjoy the economic life of the vehicle much longer than the loan terms.

Examples of Good Debt:
- A home purchased with a 15 yr mortgage. Student loans with a major with vocation, reasonable to high earning potential.
- New or slightly used vehicle with a 3 year loan.

Good debt is debt that can be leveraged for an economic benefit that is much greater than the cost of financing that debt.

The Reasonable

Interest Rate: Competitive. Reasonable debt will have an interest rate that is close to the average rates at the time the loan is originated.

Life of Asset: The economic life of the asset is still long-lived.

Examples of Reasonable Debt:
- A home purchase w/ 30-yr mortgage. Though not as good as a 15-yr mortgage, the buyer can still benefit greatly from selling the house after they have significant equity in the home.
- Student loan for general higher education. Even if the career path chosen isn’t a high earning vocation, people with degrees still earn more than those with only a high school graduation.
- Car loan with repayment period of 4-5 years. This should give you 3-6 years of use of the vehicle after it is paid off to enjoy the asset with no payments.

Reasonable debt is still debt that can be leverage for a greater benefits than its costs.

The Bad

Interest Rates: Bad debt has high and/or variable rates. These are typically variable rate mortgages (ARM loans) or credit cards.

Life of Asset: The economic life of the asset is short-lived or some type of consumed expenditure. Many people carrying credit card debt is doing so by purchasing material items or paying for bills to avoid falling behind. These purchases were not made on assets that benefit the person carrying the debt.

Examples of Bad Debt:
- Carrying credit card debt while making minimum payments.
- Purchasing an old car with a financing term that exceeds or equals the remaining life of the vehicle.

Again, LEVERAGE is the key word.

Any good or reasonable debt can be leveraged for a benefit that is greater than its costs.

Use these guidelines to evaluate any debt you are considering to take on in the future.