I talked about principles of personal finance in a recent post. In that post, I explained why it’s more important to know the principles rather than methods, tricks, or ideas. The first principle talked about debt and how it is generally not good. Today I want to elaborate on that principle.
Principle #1: Debt is Generally Not Good
Here’s what I said about it:
“Proverbs 22:7 says, “The rich rules over the poor, and the borrower is the slave of the lender.” Debt is pretty much the opposite of financial freedom; it is financial slavery.
Get out of debt and stay out of debt, especially high interest debt. Debt costs you money. Money going towards debt is money you can’t save, you can’t spend, you can’t invest, and you certainly can’t give away.
The higher the interest rate, the more it costs you. Some debt is super bad; other debt is maybe not as bad. How bad it is depends on what it’s being used for, the interest rate, and the amount. For example a low interest mortgage that you can afford might be wise, but high interest rate credit card debt that you can’t afford is never wise.
Generally though, the only time you should celebrate debt is when you get out of it.”
It’s Rarely Good But Not All Bad
Debt types fall along a spectrum. Some types can actually be really smart and good (GASP)! Leverage is a useful, though sometimes dangerous financial tool. It allows us to do things that we wouldn’t otherwise be able to do.
However, it can be risky, especially if you don’t have a way to pay it back. There are also debt “tools” that have been created for the sole purpose of taking advantage of vulnerable populations, especially the financially illiterate.
Below, I rank various types from one to seven.
Debt Type #1 ) Often Good – Business Loans
According to the Motley Fool, there are only 10 companies in the S&P 500 that are debt free. The other 490+ successful companies aren’t just taking out loans for the joy of making interest payments. They are taking them out in order to grow at a faster pace than they would be able to without them.
Many real estate investors take out loans to acquire rental properties. The key distinction between good business debt and bad is whether you can safely cover the payments or not. Does the investment allow you to generate enough cash flow to cover your operational costs and your loan payments? If it does, it might be good.
For example, let’s say you take out a mortgage on a rental property that results in monthly mortgage payments of $700 and operational costs of $700 per month (finding tenants, fixing roofs, toilets, property manager, etc).
If you can consistently rent the place for more than $1400 per month, it might be a good investment. You are generating passive income that you wouldn’t have generated without the financial leverage. Once the mortgage is paid off, it’s pure profit.
Debt Type #2 ) Okay, but don’t go crazy – Mortgage Debt
On one hand, interest rates have been fairly low in recent years and you need a place to live. On the other hand, you will pay about $145,000 for an $80,000 loan over 30 years, not including taxes or insurance.
But on the one foot, what kind of person (other than HGTV people) has enough money sitting around to buy a house with cash? And on the other foot, if you did have $80,000 sitting around, there’s a good chance it would be worth $640,000 in 30 years (see The Rule of 72) if you invested it wisely.
*Full Disclosure – We have a 30 year mortgage that we’re taking our time paying off, allowing us to invest more in the stock market. We could pay it off quicker if we were putting less money into stocks.
So maybe mortgage debt with low interest rates isn’t so bad these days if you can afford your payment. But seriously, you don’t need a huge house and a huge debt. I’m pretty sure home sizes have doubled in the last 50 years despite smaller family size.
Debt Type #3 ) Not So Bad Sometimes – Student Loans
It’s good to invest in yourself but better to invest in yourself without debt. Regardless of how you choose to pay for college, you should do a cost/benefit analysis to see if it’s worth it.
Some schools are a lot more affordable than others. Some schools offer better job prospects than others. Certainly some fields of study make more money than others.
Trades like electrician or plumbing can make great careers and great businesses with far less education, often charging over $100 per hour.
The point is, do some research and take it seriously because the debt doesn’t care if you get a good job or not.
Debt Type #4 ) Somewhat Bad – Car Loans
Vehicle loans can be fairly low interest, and you might need a car, but can’t you get it without debt? A car is just a vehicle (literally) to get you from point A to point B.
With this in mind, please don’t buy a new car with debt or lease. If you can afford to buy a new car, I won’t judge you. However, if you need a loan to get a new car, you can’t afford it and should probably stick to used.
Debt Type #5 ) Usually Bad – 401k Loans
The purpose of your 401k is to allow you to retire in the future. Taking money from it, even if the interest rate isn’t terrible is dangerous. It can really kill your returns. These are dangerous and can really set back your retirement prospects.
However, using some money for a short-term need is better than racking up credit cards, payday loans, or most consumer loans even. The key words are short-term and need (See post on Needs vs Wants). The good news is that you’re paying the interest back to yourself. The bad news is that you are missing investment returns (unless the market is going down).
The real danger comes if you suddenly change jobs or lose your job and need to pay it back or take an early withdrawal penalty.
Debt Type #6 ) Terrible, Horrible, No Good, Very Bad – Credit Cards
High interest credit cards will kill you. Again, credit cards are a tool, but they are a tool that takes advantage of the financially illiterate. There is a reason credit card companies give you free T-Shirts to sign up on college campuses.
It’s because college kids love free stuff and are financially illiterate and unprepared for reality. Financial literacy is a rant for another day though. Credit Card debt is bad.
Credit cards can be great if you pay them off every month, avoiding interest payments. I use a credit card for everything I can and earn 1-2% cash back up to occasional 5% bonuses. However, I pay it off every month to avoid any interest payments or late fees.
Pay it off completely every month, and you’re good. Let it accumulate interest, and you’re in trouble.
Debt Type #7 ) Disgusting – Payday loans/ Rental Centers
There is nothing good about payday loan/ rent-to-own type places. It makes me sick driving by these places watching poor people go in poor and leave poorer. They are shady and take advantage of poor people. I’m not sure how these people sleep at night.
There’s no other hand here. The payday lenders stole it. Find any other way to get money or avoid spending it before going here.
A Few Words on Investing with Leverage
Investing with leverage is dangerous. If you don’t understand what you’re investing in, don’t do it. This includes things like margin trading, futures contracts, options, and leveraged ETFs.
The first paragraph on Investopedia says it all to me, “Leveraged investing is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest. Leveraged investing exposes an investor to higher risk.”
This to me falls into a different category than investing in a business with debt, though that carries some risk too.
Like many financial tools, debt is neither inherently good nor evil. However, on the road to financial independence, making extra interest payments is generally going to slow you down. The main takeaway is to always take the time to understand what you’re getting into. Do the research, ask questions, seek second opinions, and be informed.
Did I miss any debt types or do you think I’m off base on any of these categories?