It can be difficult to know when you're taking on good debt versus bad debt. It's not always as clear-cut as the type of debt. We've seen this with the mortgage crisis of 2008 and even the student loan problems of today. Instead, debt can be good or bad depending on your financial circumstances. To illustrate this, the team at Wela has come up with two characters:
Gary is a hard working guy who understands how to leverage debt to improve his life. Gary takes on good debt.
Barry, his neighbor, uses debt as a shortcut to get what he wants. Barry takes on bad debt.
Let's look at a few ways that these guys use debt differently throughout their lifetime.
Gary's Good Debt When Gary was 18 he took out a $20,000 student loan to cover the cost of getting his Bachelor’s Degree from UGA. Gary got his degree in Business Administration where his initial salary out of college was around $50,000. This is a significant increase in comparison to his $30,000 salary that he would have received with only a High School Diploma. With the bump in salary from his Bachelor’s degree, Gary was able to pay off his student debt within a few years of completing his degree.
Barry's Bad Debt Barry is a businessman who owns a landscaping business. Barry has overextended his capacity and taken on more than he can chew, but he feels the business is viable going forward. With employees’ salaries, fuel for the trucks and lawn equipment, landscaping materials, insurance, etc., he finds that every payment coming in is going right out the door to pay a bill. With no wiggle room and the need for instant access to cash, Barry sells his invoices to a factoring company. Essentially, Barry is selling his accounts receivable from his customers to the factoring company for cash flow now, and “only” paying an average of 10 – 15% of his receivables. Unfortunately for Barry, the reduction to the bottom line does not increase the ability to attain more business and he is forced to cut his workforce and workload by half, and eventually pay to himself also by half. A good rule of thumb is that you only leverage your receivables when you know they will grow the business and not to pay overdue bills on your end.
Essentially, Barry is selling his accounts receivable from his customers to the factoring company for cash flow now, and “only” paying an average of 10 – 15% of his receivables. Unfortunately for Barry, the reduction to the bottom line does not increase the ability to attain more business and he is forced to cut his workforce and workload by half, and eventually pay to himself also by half. A good rule of thumb is that you only leverage your receivables when you know they will grow the business and not to pay overdue bills on your end.
Gary's Good Debt Gary took advantage of a Black Friday special at Home Depot that had 5-year financing with 0% interest to completely redo his kitchen. Gary paid $12,000 for new cabinets, granite countertops, and stainless steel appliances for 60 even monthly payments of $200. Gary’s wife does a lot of cooking and had been saying that they needed to update their kitchen for a year, so he found a way to get a new kitchen within his budget (paying only $200/month) and also a way to make his wife happy! Also, Gary and his wife have two young kids and believe that at some point they will need a bigger house. Having an updated kitchen will be great for the resale value of the house.
Barry's Bad Debt Barry has bought his new 70” flat screen TV, surround system and Macbook on credit. The interest rate on this stuff is 0% percent. How on earth could this be bad? Because Barry is not saving 20% of his income for retirement/long-term savings as we typically advise. Instead, he's servicing his monthly payments for these “nice-to-have” items when, in reality, he cannot afford them because it doesn’t fall into his 50% of his income that we classify as discretionary income. The only way that he could pay for these items is by eating into his 20% for savings.
Gary's Good Debt Gary has a car loan at 0.9% that he is paying off with his monthly cash flow because he can afford this payment. He plans to drive the car "until the wheels fall off". This is a good use of leveraging debt since he is borrowing money at near nothing to pay down a depreciating asset. His car is losing value over time, but by taking the cash that he would have used to buy the car outright and instead investing it in his retirement savings, his money is appreciating at a much higher rate since he's investing wisely in the stock market over long periods of time.
Barry's Bad Debt Barry and his family were living happily in their four-bedroom home in the suburbs when they noticed that their neighbor, Gary, had started construction on a pool in his backyard. Gary, who is a smart saver, had been saving up money for the past five years to pay for his pool. As the construction was nearing completion, Barry became increasingly jealous and decided that his family needed a pool as well. Gary and his wife only had $10,000 in the bank, which was not enough to pay for the $25,000 pool, but then he remembered his co-worker mentioning that he had taken out a loan on his 401k for some home renovations. Barry borrowed 50% of the money in his 401k to cover the cost of the pool. He figured that his family would simply live more conservatively over the next few years to pay off the loan; however, he failed to realize the extra monthly maintenance costs that having a pool brings. Now Barry has bad debt and lives paycheck to paycheck trying to pay off his 401k loan, rarely getting to enjoy his pool.
Hopefully, the above examples from Gary and Barry show you how debt can be either good or bad based on an individual's financial situation. Before you take on debt, chat with Wela to learn if it's a good decision for you based on your total financial picture. Just sign in to the Wela portal to get started.