Good vs Bad Debt

I often hear that debt is bad, and actually I spent most of my life desperately avoiding all forms of debt. I never borrowed money, I just hated the skin crawling feeling I got when I owed someone something. When I finished school and got a job, I drove a ten year old car because I didn’t want a car loan, and I wouldn’t even entertain the thought of a credit card.

As it turns out, I’ve learned that there are two kinds of debt – Productive debt or Good debt, and Destructive debt or bad debt. Whilst desperately trying to avoid destructive debt, I also inadvertently made myself abstain from good or productive debt, like a mortgage.

Productive (good) debt

Good debt is debt that can money into your pocket; essentially you use someone else money to buy an asset that produces an income or goes up in value.

A Mortgage

The best example I can think of is a mortgage. If you have a stable job, a good savings history and a decent deposit you can approach a lender and apply for a loan to buy a house. The most common type of mortgage would be a principle plus interest for an owner occupier loan for 80% of the property cost (80LVR) over a 25 year timeframe. If your mortgage payments and combined holding costs (insurance, utilities, council rates etc) are less than what you were paying in rent – congrats, that debt is putting money back in your pocket every week!

Interest only loans

Even better are a form of mortgage called interest only loans. These loans as the name suggests have interest repayments only, rather than a traditional mortgage which is principle and interest (where you gradually pay down the value of the loan over the loan period). An interest only loan is never paid off, and at the end of the term you have to refinance or pay off the debt in total.

These are usually favoured by property investors that hold rental investment properties; because the interest only payments are lower, you end up with a much better cash flow or positive gearing putting money in your pocket from day one. A principle plus interest loan would mean you are gradually paying off the loan and generating equity in the property. Equity (or your percentage of ownership) is good, and you could even refinance down the track to pull out this equity for a future purchase deposit (called debt repurposing or recycling), but its not doing anything for you at the start.

Negative gearing a loan

Some people chose to negatively gear their properties, which means the cost of their loan and management costs are higher than the rent they receive. Usually people are sacrificing cash flow today in the hopes of capital gains tomorrow. Its a tax effective strategy for those on top tiers of the income tax rate, and has worked for thousands of property investors in a property boom. In a declining market negative gearing is just as dangerous as it is beneficial in a rising market. Personally negative gearing is not for me, but you get the idea.

Starting a business

Other ways debt could be good for you is a small business loan – if you desperately need capital to launch your business then you could consider a small business loan from a lender such as a bank. This could really accelerate your business allowing you to produce an income sooner. If you were an Uber driver, then a low interest rate car loan could also be considered a form of business loan as you are then deriving an income from it. But these do have their risks, and you are locked into needing to make repayments.

Credit cards

Credit cards are not always a form of bad debt – spoofing credit cards for sign up bonuses (called credit card or travel hacking) can be a very lucrative source of free travel or cash bonuses, as well as using the credit cards on everyday purchases for their cash back offers.

Destructive (bad) debt

No Money, Poor, Money, No, Crisis, Poverty, Debt, Empty

Bad debt is debt that takes money out of your pocket. There are countless examples of bad debt being used in our society, but it essentially all boils down to living above your means.

Credit cards with outstanding balances

Using credit cards to buy things you cant afford is a seriously dangerous practice, which can destroy your wealth and lock you into a debt cycle. The incredible interest rates charged on outstanding balances mean you pay a hefty premium if you cant pay it off. To the tune of 20%! There are a number of other ‘synthetic’ credit cards or payment plans like Zip or Afterpay, where you can ‘Buy now – bleed later’, but I think its worth steering clear of these unless you have a tangible business case use for them.

Personal car loans

Another bad example of debt that I see is personal car loans. I look at the carpark at my work and I usually look out to a sea of big 4WDs and other luxury cars. I wonder how many of these cars were purchased for cash, versus how many are on payment plans. The irony is that buying an expensive car using finance might make you look wealthy on the outside, but your finances are rotten on the inside and those expensive interest repayments are destroying your wealth.

I’m not always against car loans, and there might be circumstances where using a 0% interest rate finance (or delayed payment plan) on a sensible ex demonstrator (show vehicle) or second hand small car might be a smart choice if you need a reliable vehicle for work. But your generally always going to get a cheaper option buying second hand for cash.

Personal holiday loans

Ugh. If you can’t afford to pay for a holiday, you probably shouldn’t go. Maybe check out something cheaper – I love doing road trip holidays and camping or hanging out at the beach or river, which is nearly completely free (other than the cost of some fuel, beer and food). Racking up thousands of dollars on a personal loan because your scared you wont have another opportunity to go on a Contiki tour is not a sensible choice.

Pay day loans

Pay day loans are some of the shonkiest practices I have ever heard of. The sad thing is this kind of predatory lending takes advantage of some of our most vulnerable people in our society; statistics show the highest percentage of pay day loan users are single mothers, struggling to make ends meet. Pay day lenders gouge exorbitant fee’s and interest rates, and you want to stay as far away from this destructive debt as you can.

Summary

In conclusion, debt isn’t always a bad thing, and used effectively it can make you money. But having any form of debt does present you with a level of risk that needs to be managed – economic circumstances can change and you want to make sure you aren’t going to be left drowning in debt unable to make your repayments. But I will leave you with something from one of the worlds greatest investors, Warren Buffet

‘You don’t need to use debt to make money, and someone who doesn’t understand debt certainly has no place getting into it”

Warren Buffet, CEO Berkshire Hathaway

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CaptainFI

CaptainFI

Join me in a journey to reach financial independence by making money work for us, and not the other way around. Learn how with hard work, self discipline, patience and some diligent investing, you too can reach Financial Independence and Retire... Eventually. Get FIRE'd!

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