The Good Debt
The Good Debt
We learn at a young age about the nexus between good and evil. In that for good to exist there must be evil out there. This is played out in cartoons, movies and in real life. Disappointingly, we often don’t learn about the difference between good vs evil debt. Is there even such a thing as good debt?
It’s a difficult subject to broach as often people don’t understand debt and how it can work for, or against them. They hear that debt is bad and so assume all debt is bad. When we as advisers try and have a conversation about debt it can come across as condescending. So here goes. Hopefully a not so condescending discussion about debt.
Some types of debt can be beneficial. Businesses use debt all the time to generate revenue. They borrow money (often they refer to it as capital) to buy plant, machinery, hire staff or invest in technology. This is good debt. It creates income which should ideally be higher than the debt costs and the business generates more income to make greater profits for the shareholders that took the risk. There is a reward for the risk taken.
The same can be applied to our personal lives. I good debt should increase your wealth over time as well as providing you with utility, that is fulfill a need for shelter, transport etc. Let’s look at some examples:
- A mortgage to buy your home is a good debt. It provides shelter, stability, security and a sense of community. These are hard to put a price on. The property you buy should also appreciate in value over time. This type of debt should enable you to increase your wealth.
- A student loan to pay for your education is a generally speaking good debt. It funds important educational items like books, course fees, accommodation and living expenses while you are at a stage of your life where you have little income coming in. In doing so you are improving your qualifications and future ability to earn an income. It may even pay for the odd drink or two, which I would argue helps develop important social skills!!
- We are often asked “should I buy a property as an investment or invest in shares”. You can do both. Invest cash in a portfolio and take out a mortgage to buy an investment property. A mortgage to do this is a good debt. This is often referred to as leverage. There are some good advantages of buying an investment property using a mortgage. Here is a link to an old informational video we made about the advantages of an investment property mortgage. https://www.youtube.com/watch?v=gmRVSh5s_6k You should also make yourself aware of the risks which can be found here. https://www.youtube.com/watch?v=Ku0bQbnpNFM&t=147s We can also provide some modelling for you on this.
- Using leverage to buy investments can produce higher returns. However, this comes with high risk due to greater volatility and tolerance for poor performance. It is human nature to want to get rid of something that is causing you stress. This is often the worst time to sell, especially if you have borrowed money to buy the assets. As the potential for higher returns come with the potential for higher losses. Not something for the faint hearted.
Taking on a debt is a balancing act. Good debt, at good levels can be very productive in terms of building wealth. Taking on too much can jeopardize your wealth in periods of declining economic growth or a crisis. You can often hear this being referred to as the strength of your balance sheet. In periods of decline, ideally you don’t want your assets to be worth less than your debt. If this occurs and you lose an income, an asset is destroyed, liquidated etc you can find yourself in a very vulnerable position. With no wealth you won’t find any support from banks or lenders. In fact, they will want to reduce their exposure to further loss and look to sell assets they have security over. So if your net position (assets minus liabilities, loans, credit cards etc) is weak or low, look to improve your net position by paying down debt faster.
Let’s now look at bad debt. Bad debt can be described as any debt you take out to purchase a depreciating asset. Think of things like cars, clothes, technology etc. These assets are often worth very little, very quickly. Between 1 and 10 years depending on the item. By taking debt to purchase them you are not improving your long-term financial health. Let’s look an example:
- You have $10,000 saved and want to buy a car. You decide that none of the cars are suitable for you and get offered a finance deal for a further $20,000 at 6.99%. The total you will pay for that car will be $35,434, not the $30,000 that you signed up for. The car might be worth $5,000 after 5 years. This hasn’t improved your wealth at all.
- Another aspect of debt is that it impacts on your ability to borrow. For example, recently a client looking to buy a home had about $60k worth of personal debt (credit cards and personal loans) The difference in how much they could borrow to buy their first home was almost $300,000.
If you are serious about buying a home or an investment property it pays to think twice about whether you need the item, want the item or whether you can wait. If taking out debt seems like the only option, have a look at Sorted’s budgeting tool which you can find here https://sorted.org.nz/tool/budgeting-tool#/welcome They also have helpful guides to help gain control of your finances. Generally, anything involving money, the sooner you do it the better off you will be.
Disclaimer: This is meant to be informative and engaging, hopefully not a cure for insomnia. Please don’t take this as personalised financial advice. Discuss your situation with an Advisor. This is where I need to say past returns are no guarantee of future returns.
- Posted by Isbister
- On June 2, 2021