Dear daughter,
Is debt good or bad? This is a recurrent question in many people’s lives.
There are many opinions regarding this question.
Here, I want to give you an idea of how to think about this question.
As it happens with many things in life, the answer is that it depends.
Some people consider debt as an investing vehicle. Others, only consider debt to get material things they cannot afford.
When debt is good?
I consider debt to be good when you borrow money to buy an asset. An asset is something you buy that makes money for you.
For instance, if you buy a car to use as a taxi, that is an asset. The reason is simple, while you, or someone else, drive the taxi, it will put money in your pocket.
Another common example is buying a rental property. Let’s say you buy an apartment to rent it out. Here you have another asset. Because renting the apartment will put money in your pocket.
An example of what is not an asset is a TV. A TV won’t put money in your pocket. Actually, the opposite will happen. It will take money out of your pocket.
How? When you pay for a subscription-like service or the tv breaks and you have to pay someone to fix it with money from your pocket.
Before I move from good debt, you should be very careful with everything you consider to be good debt. As I always tell you, when you make a financial decision, you must make the numbers, in detail.
If the numbers don’t work for you, then it won’t be good debt.
In the case of the rental property, for instance, you must make sure that you can set money aside to pay the mortgage (the debt), maintenance costs, tax and rates, management fees, and some others. Once you subtract all those costs from the rental you will get, if there is money left, that one is going to your pocket. And that is what you call an asset.
Going back to the taxi example, you should calculate how much are you planning to make in a month, deduct the payment debt, the payment for the driver, maintenance costs, taxes, etc. If after that, you still get to keep some money, it is good debt. That extra money will go to your pocket every month.
I hope you are now getting the idea of when a debt is good. I could say that in general, it is good when you borrow money to invest and the return on investment is enough to cover the debt, and all the associated expenses, and still send some money to your pocket.
There is an exception to using debt to invest, however. So far, every single book I read from professional investors, tells you not to use debt to invest in the stock market.
The reason behind this is that stock market investment has a long-term horizon. When you buy a stock, you will try to hold it for many years, or in a perfect world, forever. But debt doesn’t wait years to be paid, it has to be paid regularly, usually monthly.
In summary, every investment vehicle has its own characteristics. You must make sure you understand all you can before going into a specific type of investment.
A downside all debt has, without regard for good or bad, is that at any time it can be called off. Meaning you must pay the balance. Therefore, you need to be extremely careful anytime you are using debt as an investment mechanism.
To follow up on the previous idea. That is the reason why I like so much to invest in the stock market.
I invest money that I don’t need now, and I’m sure (as sure as I can) that I won’t need it soon. The money is in the stock market, working hard for me and all I must do is wait two times (or four, depending on the stock) to get paid dividends. Money going into my pockets, without having to use debt or spend my time working for money. Isn’t it great!
When debt is bad?
This one is easier to answer than the previous one.
Whenever you borrow money to buy things that won’t give you money or when the debt is not worth it.
Let me give some examples:
- A credit card that you probably don’t need and you will use to buy things you cannot afford.
- A clothing account. Here, you are borrowing money from a shop. Clothing doesn’t put money in your pocket.
- When you borrow money to buy new furniture. Furniture makes you feel good for a while, but it doesn’t put money in your pocket, it takes it out later when you have to fix it. So, it is bad debt.
- When you borrow money to buy the latest car that you like. This definitely doesn’t put money in your pocket.
- When you have debt and have/want to borrow more. Here is an example of how I realize it was bad for me to buy a car while I had a big debt, and I really didn’t need a new car.
There are many more examples of bad debt. I’m not trying to give an exhaustive list of examples. I just want to give the basics on how you can think about debt.
Whenever you are thinking about taking a debt, go through the previous examples and compare them with your current situation so you can make the right decision for yourself.
A point that needs clarification.
I’m not saying that you shouldn’t buy the latest car that you like or new furniture. All I’m saying is that you shouldn’t use debt to buy that type of thing. If you do, you are usually buying something you cannot afford.
There are also myths about debt that can help you understand better the good and the bad.
Here is a rule of thumb that works for me: I buy assets (things that put money in my pockets) using debt (if it is good debt) or using cash so later I can use the money that came from the assets to buy stuff like the latest car model, furniture, or clothing.
This is working just fine for me. If it makes sense for you, you can start applying it. The result will be this: you get money (the asset) to work hard for you, as opposed to you working hard for the money (your 8 to 5 job, for instance).
Love you, dad.