Good Versus Bad Debt - Why Patience Is Our Debt Savior

Math is a pretty straightforward subject.

1+1=2.  Not many people can argue with me on that.

However, life is not math (although some of us wish it were).  Not everything is black or white.

I think that’s what makes life so difficult.

In school, we made decisions based on a set of information that was provided to us (either in the book or within a study guide).  We knew that if we understood (or memorized) that information, we would be golden on the exam.

In life, we don’t have a study guide or a book.  Would life be more fun if we did have this book or study guide?  That could be a whole argument in itself, but it’s an interesting thought.

I digress.

We have to make decisions without knowing how that decision is going to impact us in the future.  That is why it is so difficult to categorize decisions we make as good or bad at the moment we make such decisions.

Hell, a decision could look like the worst decision ever during the immediate moments following our action.  Down the road though, it could end up being the best decision we have made to memory.

Some call that luck… I would argue that it is just life.

That’s why I think it’s funny when people start trying to categorize different life decisions, on a general basis, as being either good or bad.  In essence, they are trying to create this study guide for life.

One of these decisions that tends to be categorized is whether debt is good debt or bad debt.


Too much good can be bad

When looking at debt, we must put very loose parameters around what we think is good and bad debt.  Always categorizing certain loans as good or bad debt isn’t a great idea.

People can argue why certain debt may be good or bad.

Instead of labeling a certain debt as good or bad, let’s put a rule of thumb on what makes debt good… in theory.

Good debt should be debt that is taken on for an asset that is going to go up in value—or something that will provide increased value in the future.

The first things that come to mind for me with this definition are a house’s mortgage and a student loan.

Okay, here is where the loose parameters need to come in.

A house tends to go up in value over the long run, so getting a mortgage can add value to an individual.  Plus, people don’t tend to have the savings to just pay for a house in straight cash.  So, this would be good debt.

A student loan should lead to a college degree (or an MBA, doctorate, etc.) which should then lead to a good paying job and a better ability to grow within the company.  Again, this would be good debt.

However, just because a house should go up and a mortgage, in the above scenario, is deemed good debt, doesn’t mean you should rack up mortgage debt.  If you have too many mortgages and your cash flow can’t cover them, then mortgage debt turns to bad debt.

The same is true with a student loan.  If you go to school, rack up debt and then decide not to work, well then student loan debt is bad debt.  Also, I saw people in college rack up student loan debt by spending the loan partying.  That is bad debt.

Again, not all debt is created equal, and even too much of this deemed “good” debt could be bad.


The plastic problem

Bad debt, to me, is basically any debt that we take out for a depreciating asset.

Some examples here would be using credit cards to buy clothes.  I highly doubt that we will be able to re-sell the clothes we buy for the same price we paid.  Thus, the clothes are depreciating in value.

The key statement here, though, is credit cards.  That is the debt factor.  Buying clothes with cash is fine, but taking out debt to buy them because we don’t have cash for them is bad.

Credit card tends to be bad debt… or in my eyes, the worst debt.  Racking up credit card debt at school tells me the individual didn’t take out enough of a student loan…if the expenses are actually for education, rather than partying.  A student loan will be more favorable terms (most of the time) than a credit card.

The fact of the matter is that if you can’t afford an item with current cash, then a credit card is NOT the answer.


Debt we can argue

Car loans would be a debt that many people would put into my prior definition for bad debt.

It’s a depreciating asset… so it’s bad debt.

Here is where the parameters get a little murky.  Let me argue two situations when a car loan would actually be good debt.

First, let’s set the stage.  We are buying a $20,000 car and are going to finance the entire amount.  We get a great rate of 1.9% annually, and it’s a five-year loan.  This means we are paying about $4,200 per year.

Situation 1:Say we have saved up the exact amount that the car costs, $20,000 or even a little more.  Well, if we were to go into our savings and put the cash towards the car, we would have no debt… great!

What does that do to our emergency reserve, though?  If the $20,000 is from our emergency reserve then we’ll be left without anything in there… which is bad!  In this situation we would want to create a line item within our budget to determine if we can afford the monthly car payment if we were to take out a loan.

If we can afford the loan in our budget with our current cash flow, then I would deem this as good debt.  This way we still have our emergency reserve, and we aren’t paying an extremely high interest rate.

Situation 2: Say we have built up a good chunk of savings… $100,000, and we are looking to buy this great $20,000 car.  Some people would suggest we just pay in cash for the car and have no debt… great!

However, if we can earn 5% per year on our $100,000, while the debt is only 1.9% and our current cash flow allows us to afford the loan… I would take the loan.  Even if we were to deplete our assets to $80,000 (pay for the car in cash) and save what our payment would have been, by taking the loan we would still be ahead by about $4,000 10 years down the road.

Life doesn’t provide us a study guide, even when it comes to buying a car.


Debt doesn’t define us

Situations in life define us, and the decisions that we make define us.

That definition isn’t determined until down the road, though. When it comes time for us to determine whether or not to take debt the only facts we can use are those we have at that time.

The general parameters are a good starting point to determine whether or not the debt we are about take will be good or bad.

Always ask yourself, does the asset tend to appreciate or depreciate?  At least it’s a starting point.

Then ask yourself this, “Do I need it today or can I get it later?”  If we ask ourselves this before a decision in which debt is associated, we may be better off.

If the answer is ever that it can be later, then we should start saving for our desired object or event rather than racking up debt.

They say that patience is a virtue and it is, and when it comes to debt, it could also be our savior.