Good debt, bad debt

9 November 2021

Debt: owing any money, to anybody, for any reason. 

Most of us have an opinion (good or bad, necessary or not) about debt, whether it’s credit cards, property mortgages, or any other type of loan. And certainly the vast majority of us do have debt. Or at least if we assume Americans to be a good proxy: as of 2019, the share of American families holding any type of debt stood at roughly 77%, with a mean consolidated value of $140,000.

At a first glance, we borrow money to buy something we couldn’t otherwise afford. But we may also decide to borrow money when we don’t need it. Does that make the latter “bad debt”? Not necessarily.

Bad debt

As a general rule, borrowing money to buy something that will decrease in value (a depreciating asset) and/or will not generate an income, is not a good idea. But unfortunately that does not mean this type of debt is rare. Consumer finance, credit offered to consumers for personal use (to buy a new television, for example) is expected to keep growing globally at roughly 5% per annum, and BNPL (buy-now-pay-later) is one of the hottest themes in fintech at the moment.

Lenders make money when they lend it, so it won’t be them telling you not to borrow. And governments won’t tell you that either, when they want us to keep consuming so that the economic machine can keep growing. Central banks incentivize borrowing with monetary policy interventions aimed at lowering the cost of debt. That affects the cost of having any kind of debt, good or bad. And a lower cost of debt can blur our judgement on good and bad debt. If it’s cheap, how bad can it be?Bad debt may be acceptable or unavoidable (car finance for example, when you do need a car to go to work but can’t afford to pay for it upfront, and the borrowing cost is not crazy high), or may be categorically bad. The worst of it all? Without a doubt, credit card debt. If you don’t pay your monthly balance in full and you roll it over to the next billing cycle, you will incur monthly interest rates of 3-4% (40%-60% annually). Ignore that at your own peril.

Good debt

Being the opposite of bad, good debt is money that generates (or is expected to generate) a return that outweighs its cost. Also known as leverage, this type of borrowing can greatly amplify the return on an investment. Or wipe it all out. So you have to tread with caution.

Investing in your education is generally regarded not only as necessary, but also as good debt. You are investing in yourself, so hopefully you will not turn out to be a depreciating asset and you will generate an income that is larger than the cost of your university loan. House mortgages are also good debt, and particularly so if you buy a property in a stable, growing market. 

But what about the subprime meltdown of 2007? What defines good debt is not just where the borrowed money goes, but also who the money goes to in the first place. The housing boom of the mid-2000s and the low cost of borrowing induced many unscrupulous lenders to offer home loans to people who should not have been able to borrow, and who could not make good on their liabilities when the real estate bubble burst.

Leverage goes both ways

So good debt is money you can afford to borrow, and which you invest profitably. 

That does not make it risk-free though. As mentioned before, leverage goes both ways: it can boost your returns, or wipe out your equity. If you invest $100,000 at 7% for one year, and borrow 80% of that amount at 1%, you are actually investing only $20,000 of your own money: When you get $107,000 a year later, you return the bank $80,800 and pocket $26,200. Leverage boosted the return on your $20,000 from $1,400 (if you had only invested your own cash at 7%) to $6,200 – or 31%. But if in 1 year that 7% did not materialize and you only got back $95,000? The 5% loss that you would have suffered on your own cash alone – or $,1000 – would have ballooned to $5,800 (-29%), since the bank still needs to be paid back in full, and with interest.

The larger the differential between borrowing cost and investment return, and the larger the percentage of debt in an investment, the greater the impact of leverage will be. For better or worse.

What’s your risk profile?

So when is it a good idea to take on good debt? When it is more likely to be good, i.e. when it is more likely to be invested profitably. That is, when the cost of borrowing is low, and certainly lower than the return on the investment. And of course, when the investment is least likely to implode. 

It’s easy to identify the extremes in a range: borrowing half of the money to buy a property in a historically-stable market on one end, buying entirely on credit a newly-created crypto currency or a single stock with little liquidity in some unknown market, on the other end.

Every data point in between these hypothetical extremes is down to the individual’s risk perception, appetite and competence.

Conclusions

Pay your credit card balances every month. And if you are caught in a downward spiral of unaffordable credit cards, consider a loan to pay them all (a consolidating effort will most likely result in a lower overall cost).

As a rule of thumb, any debt that charges more than 5% annually is immediately bad, or if you know a no-risk investment with a 5% annual return please do tell us! Be cautious with good debt, because no debt is good if it doesn’t make you money (or even worse, if you can’t afford to pay it back).With Exirio you can track any type of debt, and when you track mortgaged properties you will be able to fully appreciate the benefits of good debt as the investment metrics will automatically show the performance not just of your real estate assets, but of the equity that you invested in them.

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