We have all heard the horror stories in our own lives attributed to debt, but is all debt really bad? How can one man’s 100k soul crushing debt be another man’s tool to accomplish hopes and dreams? These are thoughts I’ve struggled with for over 10 years, and continue to debate in my head to this day. I can remember a time when the debt was absolutely crushing and offered no hope of ever reaching our ultimate goal of financial independence. We were living, breathing and dreaming of getting rid of the debt just to escape the feeling of drowning in it. Contrast that to now, where we have rid ourselves of the bad debt. Now we are working to use a limited amount of good debt to acquire assets and build wealth.
Ultimately looking back, I made a few poor decisions as a younger man. One of which was the amount of “bad debt” I had accumulated. I define bad debt as any debt that is used to purchase a liability. I have come to accept this definition from reading the book “Rich Dad, Poor Dad”. If your ultimate goal is to retire early or achieve financial independence, adding a liability your monthly cashflow is putting you further from your goal. A few example of bad debt would include:
- Auto loans, America’s favorite depreciating liability, do you want the façade of being wealthy or to actually be wealthy? According to a recent Experian survey, the average used car loan payment in Q4 2016 was $364.
- Consumer debt, any contract that forces you into monthly payments including cell phones, gym memberships, furniture leases.
- Lines of credit, Don’t use them for purchase of liabilities or fluff.
- Student loans, many people (including everyone in my family) work through college and obtain no debt.
- Credit card debt, I’ve made mistakes using these like a savings account… in the end it was a bad idea and cost me greatly.
- Payday Loans, I’ve been in such bad shape I couldn’t get accepted for one of these, and thank goodness. These with the high interest and fees are like a black hole where no sun shines, avoid them like the plague.
Just to quickly show how “bad debt” is robbing a lot of people of their chance to build wealth. If we took that $364 a month car payment and invested the money every month over 10 years, and it grew at a conservation rate of 5% per year(compounding quarterly), the account would be worth $57,292.72. (or $304,654 after 30 years)…. At 10% per year compounding interest, the figure gets ridiculous. You can play with some numbers using this simple savings calculator click here.
I can only think of one type of debt that I consider an “ugly debt”, medical debts due to unfortunate events or circumstances. They are what they are an unfortunate roll of the dice, but should be tackled and settled.
Moving on to “good debt”, this would include any debt used that results in a net positive to your monthly cashflow. Opportunities don’t always present themselves when you are ready with extra cash, but debt can be a tool that enables you to purchase the asset and grow your cashflow. There is debate among gurus in the personal finance field that feel very strongly one way or the other about any debt being considered “good”. For example, the author of “Rich Dad, Poor Dad” Robert Kiyosaki feel debt resulting in positive cashflow is good, where talk show host and author Dave Ramsey feels all debt is bad.
Some examples of good debt might include:
- Mortgage loan to pay for a rental unit that has a positive monthly cashflow,
- Business loan to acquire new equipment that increases capacity or productivity,
- Loan to acquire a new business that has a positive cashflow,
- Line of Credit to cover short term funding on a house flip or construction that increases investment property value, etc.
Healthy Debt Ratios
You really could go to extremes on either end of the spectrum and be successful, load up with a lot of good debt, or use no debt at all and finances everything with cash. My view is, it seems no matter how hard a person tries to avoid mistakes or bad luck, eventually bad luck appears to challenge every man’s financial foundation. So recognizing this I shoot for 25% or better equity on investment properties. I don’t have experience using debt for the purchase of other assets. Then there is the consideration of paying for the debt even if you were to loose income. The rule of thumb I like is to keep 6 mo worth of expenses in cash to cover any potential bumps in expected income/cashflow. This often requires having a large cash reserve built up before considering to take on the debt. So for example, if I know we want to take out a loan for a rental house worth 100k, we would save up 25k for a down payment and 6 mo of expenses on the property(including principle, interest, insurance, taxes).
References and Resources:
- “Rich Dad, Poor Dad” by Robert Kiyosaki
- Experian “State of Automotive Finance Market”
- Dave Ramsey Show