Good debt, bad debt
Last week’s discussion on debt aversion triggered off a thought - how do you know whether your debt is good or bad?
Money defines it as “Good debt includes anything you need but can’t afford to pay for up front without wiping out cash reserves or liquidating all your investments”. Kiyosaki’s definition, as I’ve understood it, is around whether you’ve used it to buy an asset (something that earns income) or a liability. And Jimhad this post where he gave some good examples.
The problem lies in the gray areas. Quite a number of debt decisions can be very clearly classified as good or bad; A monster SUV, or the holiday in the Alps, when you’re barely making ends meet would get voted bad debt by a landslide. Whereas borrowing at a lower rate and reinvesting for a higher return would be considered good debt. The problem is when you don’t know what the returns are going to be, or if they’re dependent on chance.
Let’s illustrate with an example here.
You’re a one-man startup, having put all you’ve got into your venture, no spare cash at hand, and you haven’t started earning.
a) Would you fly off for a week to another place, stay at a five star hotel that charges through the nose, and charge it to your credit card? You don’t have the money or the income to pay it off immediately.
It depends. On why you’re travelling there. If it’s a ski holiday, not very prudent. If it’s to a venture capital networking event, might be the best decision you’ve made.
b) So okay, it was a networking event. But your pitch didn’t make the grade. No interest - not even a whiff of one. What now?
c) Or worse - you did get an investor. Not an angel, though; it cost you an arm and a leg, and he wouldn’t let you write off this trip as a business expense. Fast forward six months, and despite best efforts, the startup doesn’t take off.
Good - or bad?
Yet another possibility, using Jim’s balance-transfer example. You took a 0% transfer, put it in Emigrant’s 4% for six months, and are all set to scoop up the gravy. You don’t have any other money with you. When it’s due to be returned, Emigrant messes up the transfer. So you couldn’t pay it off on the due date; you miss a month or more, and your interest rate jumps to 24%.
If it’s less than a month, you’re still fine. But if it’s more, you’ve just paid out more than you earned. Still good - or bad?
It isn’t a “one-size-fits-all” way of classifying - nor at a point in time. Rather, it’s context specific - and also depends on how the situation unfolds.
Another classic controversy is buying your own home. Kiyosaki is quite explicit about considering this a liability - it doesn’t put money in your pocket, it takes it out. So by inference, he’d probably consider it bad debt. On the other hand, quite a number of other financial gurus would classify it as good debt.
We aren’t talking about McMansions here - the super duper home with the million dollar price ticket. Just your plain and simple home around the corner - and maybe down the corner as well. Nothing fancy or expensive, one of millions around the country. You’ve got a mortgage, all expenses (including taxes, maintenance and repayments) coming to less than what you’re paying to rent an identical one right now. But you’ve got to take on debt to own.
So what’s the right decision? Rent - or buy? Good - or bad?
That’s debt - with a repayment. Goes out of your pocket, doesn’t bring an income. Qualifies for Kiyosaki’s “liability” definition; and therefore, bad debt?
But then, while it doesn’t bring in an income, it does reduce your spend. Remember I said - the cost of owning is less than your rental. So you’re spending less on housing; and to boot, you’re paying off the cost, whereas with a rental all you own are the receipts. Isn’t a dollar saved, a dollar earned?
Still worried about satisfying Kiyosaki? Simple. Find a friend with the same dilemma. Both of you buy identical houses. You rent his place, he rents yours. So
- You’ve borrowed to buy a house, which you’ve rented out.
- The rental income is more than the cost of repayment, so it’s money in your pocket.
- From Kiyosaki’s definition, that’s an asset - and therefore, good debt.
- But you’re living in a house that’s identical, as good as your own. Money wise, it’s the same - your extra income is offset by your rental payment, your net outflow is the repayment.
Is that good debt now?
Go forward a few years, two possibilities; we’ll ignore the “no-change” scenario.
- The area’s boomed, rentals and values up through the roof, you’ve got an option to move elsewhere in the country and cash out.
- The other extreme - rentals and values in the pits, you don’t have alternative options.
Good or bad?
Ultimately, it isn’t the original decision that defines this; it’s what happens afterwards. A case of the ends justifying the means.
Written by 2cworth on March 14th, 2006 with
4 comments.
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#1. March 14th, 2006, at 1:21 AM.
Well, I think its fair to say no one is going to make a deal like that with their friend to buy/rent houses. If you carry a mortgage on your own house but borrow more to buy another house which creates positive cash flow then that’s the good debt. Also, it’s difficult to see how a good investor is going to buy a house that depreciates in value or is in an area where the rental value may drop. It could happen sometimes, but I think the odds are sort of low. How many people do you know whose house has declined in value? Besides if the value declines, you can depreciate the house and/or hold on to it till the value returns to normal or increases. Overall, you make some valid points and interesting arguments. Good post!