We all have preconceived notions or opinions about debt.
Whether debt is poisonous to our finances and the source of our money stresses or acts as a fertilizer and financial tool often depends on how dept is employed.
Whether you enjoy the stress-free lifestyle that living debt-free brings or you have no issues using debt to fund purchases and investments, understanding the differences between good and bad debt can help ensure that you take the steps necessary to secure your financial future and not fall victim to the crippling negative side effects that come from overleverage.
Most of our feelings and knowledge about debt comes from our experiences growing up or our direct interactions with the bank. Perhaps, your family struggled financially because of frivolous spending fueled by personal loans and credit cards. If you grew up watching your parents struggle to pay off loans or have lived through bankruptcy yourself, debt may not bring about the best emotions.
Alternatively, if your family used debt responsibly and in moderation to purchase a home or other real estate, start or grow a business, or for other ventures that produce a return on investment, you probably view debt differently because of this perspective and relationship with debt.
What is Debt?
Debt comes in many shapes and forms, but at the end of the day, anything that you have an obligation to repay within a certain time period is considered as debt. Whether you use credit cards where a financial institution fronts the money for your purchase and requires you to repay the bill the following month or you have a mortgage on your home, you probably have an ongoing relationship with debt.
At its core, debt represents a financial instrument that fuels and expands the results of whatever choice you make.
This is why debt is often referred to as “leverage” in business or real estate. Just like fertilizer can be used in agriculture to grow an even larger, healthier crop yield, debt can be used as financial leverage to multiply returns or give you control of a large asset that you cannot afford outright. However, just like fertilizer used in the wrong quantity can chemically burn and kill the crop field, using debt irresponsibly can leave you in financial ruins.
Why Do We Use Debt?
Debt is a mediator and conduit between a financial institution or individual who has excess capital and another individual or institution that has a financial need for more money.
For borrowers, the enticing proposition debt offers is that you are allowed to pull forward your future income today for a certain fee (the interest on the loan). For businesses that utilize some debt, the cash from the loan can be used to reinvest in the business and earn an even greater sum of profits that can be used to repay the loan and produce an additional return that would have otherwise been produced further down the road after profits had been generated.
For some individuals, debt may not be necessary to fund their next purchase or investment. However, they may choose to do so in their personal or business ventures because the “cost of capital” is lower than the return they earn elsewhere.
Debt Allows for Margin
For instance, an individual looking to buy a new vehicle could have investments in the stock market that have historically returned 10% per year. In order to fund their purchase, they could either sell their investments to purchase the vehicle or take out a loan at 3% to finance the purchase.
In a perfect world that provides stable returns, they leave the money invested and ultimately earn a higher rate of return over the course of the loan. While there is certainly more risk with assuming debt, if the market continues to produce returns in line with expectations, they would not have missed out on the upside of the investment returns.
Their balance stays invested and earns 10%, offset by the 3% in interest paid which nets 7% on the cost of their purchase. Therefore, debt allowed for margin in this hypothetical, elementary example.
The Lender’s Investment
On the other side of the transaction, debt is an investment from the perspective of the lender.
Whether the investment comes from a wealthy individual looking to grow their revenue streams from a private loan or from a bank who has cash sitting on their balance sheet that they want to invest at higher returns, lenders must assess the likelihood of default and actionable recourse, amount at risk, opportunity cost, and the length of time on the loan to decide whether to lend their money and the interest rate to apply.
Once a lender assesses the relative risk based on the likelihood of repayment or securitization of the loan, they issue the loan with an interest rate that reflects the imputed risk of default.
Types of Debt
Generally, there are two main types of loans – secured and unsecured.
Secured Debt
Secured debt is backed by the asset the debt was used to purchase.
Typically, a lien, title, or other legal form gives the lender the right to claim the asset in the event the borrower is unable to fulfill their obligation to repay the loan. From the lenders perspective, a secured loan is much less risky compared to an unsecured loan. As a result, the interest rate associated with a secured loan tends to be much lower due to the collateral.
For instance, if you took out a secured vehicle loan, the lender would have a lien or claim to the title on the automobile in the event you stop making payments. They could then repossess the vehicle, sell it, recover much of their cost, and ultimately sue for any residual difference until they are made whole.
For a home mortgage in default, the lender may foreclose on the home and enter into the eviction process and force a sale. This allows the lending party the opportunity to recover a substantial portion of their principle. Because most homes have a net equity position due to the down payments required, principle reduction through monthly payments, or increase in the home’s value, lenders are generally exposed to much less risk when making these home loans.
As a result, the net cost of borrowing for a secured, home mortgage tends to be much lower which allows for greater affordability.
Unsecured Debt
On the other end of the spectrum you have unsecured debt.
While the borrower still has a legal and moral obligation to repay the loan, no specific asset backs the loan as collateral like with the secured debt previously discussed. For this reason, the interest rates on this type of debt generally tends to be much higher. The higher rates account for the increased risk the lender assumes in the event of default.
Examples of unsecured loans and debt includes credit card balances, private student loans, payday loans, medical debt, and some personal loans.
These unsecured loans typically do not have requirements for a specific use like secured loans that require that the proceeds fund its intended obligation. While the creditworthiness and ability of the borrower to repay is generally considered, typically, the interest rate on unsecured loans is much higher because there is no tangible asset that could be repossessed in the event of default that could be sold to recoup any losses.
What is Bad Debt?
In addition to the two types of debt discussed (secured and unsecured), there are also two additional categories of debt – good and bad debt.
Bad debt is the most infamous of the two. Most Americans struggle financially due to their relationship with debt not used for productive, wealth building activities. Instead, they take on debt in order to fuel a lifestyle and purchases that they could not otherwise afford.
While you may initially feel good driving that new BMW or laying down on that new, king-sized mattress you financed over three years, these habits and the relationship with bad debt will greatly hinder you from building wealth and having control of your financial future.
While bad debt can certainly be associated with secured debt such as a vehicle loan or even a mortgage under the wrong circumstances, most would agree there are certainly more egregious examples of bad debt in the unsecured category.
Credit Card Balances
One of the biggest offenders of bad debt is credit card balances.
For the most part, consumers utilize credit cards to buy items that we consume on a daily basis, purchase goods or services for entertainment and pleasure, and for other monthly expenses. Because there is a delay from the time a purchase is made and when consumers ultimately get the bill, there is much less pain associated with buying goods on credit.
According to studies conducted on shoppers’ behavior, individuals who used credit cards while shopping spent twice as much as those who paid in cash. For this reason, many consumers find themselves deeply in credit card debt without even realizing where all of their money is going.
Coupled with the fact that interest rates on credit card debt can hover around 20%, carrying credit card balances will greatly impede your financial success.
What is Good Debt?
I know, “good debt” sounds like an oxymoron.
However, unlike bad debt, consumers use good debt to buy appreciating assets, earn more income, or invest and grow a business. Therefore, when used responsibly, good debt employs leverage to amplify expected returns.
Real Estate
One prime example of good debt comes in the form of real estate ownership.
While not every real estate transaction may be a worthwhile and profitable example, leverage allows investors and those buying primary residences to own and control 100% of a high-cost, generally appreciating asset with a relatively small amount of their own money involved.
As an example, very few people making the median U.S. household income of $61,000 can afford to purchase the median-priced home of nearly $227,000 in cash. Often, consumers may work and save nearly a 7 years just to afford the 20% down payment to avoid private mortgage insurance (PMI).
Therefore, by utilizing leverage, new homeowners control 100% of their largest asset with a relatively small equity position. Over time, they continually build more equity until they eventually pay off the mortgage. In the meantime, the asset generally appreciates along the way.
While expenses certainly exist in the form of interest and mortgage, generally, the value of the asset purchased does not degrade in value like purchases using “bad debt.”
Other Examples of Good Debt in Business
In business, debt may be used as working capital to fund operations or further invest and grow the company.
By using a portion of debt to fund operations and growth, management intuitively determined that the cost of debt was less than the cost of equity. Therefore, management made the decision not to dilute existing shareholders by offering more shares.
The cash proceeds from borrowing can be used to invest and grow the business and eventually repay the debt balance out of excess cash flow that the use of debt generated.
However, debt can often be a two-edged sword. Should market sentiment shift and sales dry up, the debt must still be repaid. If the company or business cannot continue to make the required payments, the creditors could force the company into bankruptcy restructuring or liquidation.
You Decide: Is All Debt Bad?
While we outlined cases for and against debt, you must decide if using debt will ultimately be the right decision for you.
Some ardent Dave Ramsey fans avoid debt at all costs. For the majority of individuals, the wisest choice may be avoiding debt altogether since most consumers cannot help but overspend and lack the diligence to save.
However, some responsible consumers or business owners may realize the leverage potential for using “good debt” in certain transactions.
Ultimately, debt results in increased risk. In the end, you must decide for yourself if the potential benefits outweigh the pitfalls that come with overleverage.