I have always observed society in general looks down upon going into debt. People feel uncomfortable and out of place when they have to borrow large amounts of money to buy the things they want. So the most common notion is a large amount of debts should be avoided. A small amount are fine as long as you can afford it to pay it off (which is clearly the wrong notion).
I was seated with a group of a friend the other day and we were discussing raising money for a company we were all trying to form. The business model made sense and the upside to the investment out weighted the downside. Yet one statement made by a friend of mine particularly caught my attention. He said, “No one should form a business with debt (at least initially)”. The conversation flowed on but the summary of it majority of the people cannot differentiate with good debt and bad debt. This inability to differentiate the two is exploited by many organizations during our lifetime.
However, every person should be aware of the quantum of debt they can afford ( a sensitivity analysis of the cash flow factoring the major variables will give you an idea. If it sounds Greek ask a friend who is conversant in finance to help you).
So what is the difference between Good / Bad debt? Let me explain.
What is good debt?
Any debt that helps you make more money and increase your net asset position (that means positive cash flow after factoring for debt repayment or has any value increase of the asset acquired over the period of time a.k.a capital gains).
Student loans
If you need to obtain debt to get a college/university education this is an asset. Graduates, especially in degrees leading to professional jobs, have a higher earning potential over their career opposed to students joining the workforce soon after school (high school).
However, you should be mindful of the degree you pursue has a commercial value that can be derived in the near future for the loan repayments to be made. If not it may not be a financial viable decision ( I do understand that some people do follow their passion hoping it will open up an area which will enable you to earn more. It’s a gamble that might pay or not pay off, as long as you can take that risk then it is fine).
Example: Going into debt of over USD 200,000 to do a degree in Anthropology is risky if the entire amount is funded via debt and you have very little assets outside of that to service it apart from a job (Please don’t argue with me there are X number of jobs which pay significantly higher salary so its justifiable, I am not referring to positions which are outliers but the average pay across the board). However, it is very common for Doctors to accumulate large amounts of debts initially as students as their average pay is high, thus a lower risk of defaulting repayment/ servicing debt.
Real estate (including homeownership subject to conditions).
Any investment in real estate via debt can be termed as good debt. Returns in real estate (especially on the rental front) are two-fold. Firstly the cash flow generated from the asset and secondly the capital appreciation of the asset ( which will only realize at the time of sale).
As such homeownership will qualify for this if the idea is to save on rent over the long run and invest the difference in other assets or if the idea is to sell the property after a certain time to materialize the gain and relocate to a cheaper area. However, if you buy too much house it’ll work counter-intuitively ( I do not call the home you live as an asset but let’s leave it for another day).
Business Ventures
Any legitimate venture that is bringing some value to the market and generates a positive cash flow which is funded via debt is good debt. These sort of investments will initially derive only positive cash flow benefits which will lead to much more economic prosperity especially considering an exit at a later stage. Approximately 90% of small business fail within the first 3 years. So make sure you pick an area where you are passionate and knowledgeable.
What is bad debt?
Any debt that is spent on a depreciating asset/good which in effect reduces your net worth can be termed as bad debt. Majority of the consumer debt falls into this category.
Cars
While you may require a vehicle to get about to work having to pay interest on that is a killer. Especially if you are driving a fancy car which is way above on what you can afford you will also be incurring an above-market insurance cost and maintenance cost.
To top it off your car is a depreciating asset and in case of some models have very less re-sale value so your impact may be more than the initial depreciation if you plan on changing models soon. So next time you think of having fancy set wheels think to your self who are you really trying to impress? Focus on functionality ( At least until you have money to burn after reading this blog. As a mark of appreciation, I would be accepting any car with 0-60mph in sub 5 seconds range. Very reasonable.
Clothes, consumables and other goods services
If you spend money on designer clothes, branded jewelry, 110 inch TV, etc. which has little to none economic value addition and the same utility could have been obtained by a lesser product then you are at the losing end. To purchase these with cash is also a stretch but to purchase them with debt is a bigger mistake.
So what do the organizations do? Break it into smaller installments over a longer repayment period to mask the true cost of the purchase. If you do not have the discipline to resist these urges at least make sure to negotiate a zero percent installment scheme to obtain the best deal. Also always independently do the math and see. They very conveniently add some charges if you look gullible.
Credit cards
Majority of consumer spending on credit can be summarised as follows; “spending money you don’t have on things you don’t need to impress people who don’t care”. So unless you can settle your credit card bill in full at the end of the month don’t even think about that new drone you wanted, that designer bad on discount only for today or the fancy vacation you wanted to charge out on the credit card. The interest rates are exorbitant and more or less a never-ending trap once you get caught. In Sri Lanka, the monthly interest rate is approx 2.5% at the time of writing posts. Yup, that’s why the bankers adore you when you don’t settle on time. We don’t want our bankers to adore us (unless your spouse/ significant other is a banker but still Settle in full ).
Other forms of debt which may fall into both.
As you increase your financial literacy and understand financial products there are other types of instruments which may fall into either category. For example, if you are trading on margin credit in equity, debt or forex markets things can go south pretty soon if you don’t know what you are dealing with but can have huge upsides if you are on the right side of the trade. Areas like P2P(Peer to Peer) lending are just coming up in Sri Lanka. These can be very profitable if you have a good credit score with access to credit but as I said, you should be approaching these with caution.
The list is not exhaustive but I wanted to give a general idea on how to evaluate the type of debt. If I missed an area comment below/ DM me. We can all put our heads together to see where it lands.
Keep following this space and enjoy what you do and don’t live for the weekend.