In the world of personal finance, if there was ever a more debated and polarized topic, it is around whether debt is good or bad. There is an entire spectrum of views on this with people on either extremes and with some folks in different parts of the middle. Taking on debt is fundamentally as much an emotional decision as it is a financial decision. Of course, if you talk to Dave Ramsey or his followers, they will give you a black or white answer – which is to avoid debt at all costs. My view is more nuanced. So the answer to the question is – it depends. So let’s dive in.
The financial analysis
In order to answer the question, lets start with understanding the numbers behind it. There are 2 aspects to debt to understand for you to decide whether this debt makes sense or not.
- The cost of borrowing – how much interest you have to pay to borrow this debt.
- The purpose of borrowing – is this money being borrowed to finance the purchase of an investment (buying an asset that provides you returns) or to purchase a personal-use item or service.
You can put this in a 2 by 2 matrix to assess your decision like this. Below is just some guidance that I would have for you on a more general basis – there may be some exceptions.
So let’s evaluate the kinds of debt that you could have in each of the above boxes in the matrix. Before we do that, let me define what I mean by a personal use item or service and what is an investment.
Personal-use item or service
This can include anything from your daily living expenses to buying a car, going on a vacation, buying stuff for your house, clothes. The one controversial thing that is debatable is your personal residence. Some people call it a personal purchase and others consider it an investment. Personally, I consider this a personal purchase from the perspective that this does not generate returns for me.
Investment
Debt can be powerful if used correctly. With a small amount of money, you can purchase an asset worth a lot more. But it is a double edged sword and you need to be careful.
An investment by definition is something that generates returns for you either through ongoing cash flows or in the appreciation of the asset. Obvious examples are stocks, bonds, investment real estate. You can also invest in a business. Some people put their personal residence in this category because they expect that to be an asset that actually (hopefully) appreciates over time. They wouldn’t be wrong with that definition. Another item that is interesting and can fall under both categories is education (college or graduate degrees are typical examples but it can be any kind of education). Depending on the kind of education you are getting and the expected returns, this could fall under either category. I actually considered the pursuit of my MBA degree an investment. A close friend of mine decided to invest money in photography classes but he had no intention of making money from it so for him it was purely a personal-use service.
One more thing – why do people borrow money to invest?. Why not simply pay in cash? This is where debt (or leverage as some people call it) can be powerful. With a small amount of money, you can purchase an asset worth a lot more with debt. But you need to be careful here because if the investment value goes up, then this was a smart move. But if the investment value goes down, this is going to make things really bad and you will owe more money than you originally invested. So depending on the asset you invest in, this can be risky.
Having made the above definitions, let’s examine the different quadrants of the 2 by 2 matrix. Let’s start with the bottom left.
High cost of borrowing/buying a personal-use item or service
Borrowing money at a high interest rate to buy an expensive car or a boat or fund a vacation are examples of things you want to avoid typically.
The definition of high cost is going to change with time. The typical way to think about this is by looking at the prevailing prime rate. I talked about this a bit in my article ‘Do I payoff debt or invest’ . For purposes of this, let’s just use a rule of thumb that these are interest rates that are north of 3% + prevailing prime rate. Credit card debt is the classic example that carries double digit interest rates. Using credit debt to simply fund your daily living expenses is a dangerous way to live. (Note: what I mean here is not paying off your credit card in full each month but using their revolving credit. I use my credit card each month for my day-to-day expenses but I pay it off in full each month.). Borrowing money at a high interest to buy an expensive car or a boat or fund a vacation are also examples of things you want to avoid typically. I don’t meant to make a judgment here but the above examples may indicate a person not very responsible with money. Now, there are situations where someone might need to do this for emergency purposes and if you absolutely need to do it, do it but have a clear view of how you are going to pay it off. Otherwise, you will end up like the people in Netflix’s Squid Games. Ok that was meant to be a joke but hopefully you know what I mean.
High cost of borrowing/buying an investment
This is where you may be borrowing at a high interest rate to buy an investment. I know a lot of savvy investors who do this kind of borrowing but use it as an extremely short term loan and are able to refinance that loan to a much lower rate after some time or they simply pay it off. A good example of this is hard money loans (at the time of writing this article can be around 8% – 10%) for funding a purchase of investment real estate. Real estate investors might borrow money using the property as collateral to buy typically a run down property at a discount. They will fix it up, rehab it and then refinance the loan with a more traditional lender at better terms and payoff the hard money lender. This is fairly common in the real estate world.
I have an example here from my personal life that I touched on earlier. When I first came to the US, I did not have access to low cost student loans because I was an international student. I had to borrow money from Sallie Mae at I think around a floating 6% + prime or something like that. So at that time, those loans carried interest rates of around 13%! I know a lot of my fellow international students did the same. I pursued an MBA degree and maybe I was a bit naive or just felt this was a low risk option at that time. But I always viewed the degree as an investment and I aggressively paid off those loans in less than 4 years after I graduated. I was fortunate to have found a nice paying job that enabled me to do so. The investment continues to pay off to this day. So this was probably the best investment I ever made in my life. But this was not unique to me. As I said, a number of my fellow international students did the same and have done even better. The risk is to ensure you find a job that enables you to pay off the loans. We hear of people borrowing a ton of money to pursue degrees that don’t pay so well. So it is very important to assess this carefully.
Low cost of borrowing/buying an investment
This is the best place to be. But be careful about how much debt you take on.
This is the best place to be in really. If you ever want to buy an investment and you get to borrow money at a really low rate, then you should do this as long as you have a plan. At the time of writing this article, mortgage rates are at historic lows. You can buy real estate at a rate lower than inflation. Personally, I have taken advantage of this and purchased rental real estate that gives me returns higher than the rate of borrowing. This is probably one of the biggest promises/advantages of real estate. You can really build wealth faster with debt if you do it right. People also do margin trading where they borrow money from the broker to buy more. Currently, and in the last few years, the stock market has been on a tear so the margin traders are all feeling bullish and smart. But remember you need to always assess the risk.
One thing to keep in mind with taking on any kind of debt is how much debt are you taking on relative to your income. If you take on too much debt, that can be risky. We have heard stories of people buying rental real estate by putting no money down by basically taking out loans on another property that was also leveraged to begin with. If you are not careful, this can fall apart like a house of cards. So always be mindful of how much debt you take relative to the income and make sure you have cash reserves.
Low cost of borrowing/buying a personal use item or service
You get to decide what to do with your money and how you spend it. My only guidance is that you try and avoid borrowing money to fund these.
This is the last one and something that different folks are going to have different philosophies depending on the item you are purchasing. In my life, there are only two items that I have purchased that fall under this category and will be common ones for most people – a car and a personal residence. Financially speaking, I now actually regret buying cars using loans. A car is a depreciating asset and I have told myself that going forward, if I can help it, I would prefer to buy only used cars in cash and not borrow. But like millions of other homeowners, I have purchased my personal residence using a traditional mortgage. I could not afford to buy it in cash and interest rates have been low. I do know some folks who have been borrowing against the equity in their homes for low rates to finance home improvement projects. It’s obviously a personal choice but I personally advocate against that. I prefer to pay for those projects in cash.
Fundamentally personal use items are items you buy that do not give you any returns. But you buy them for your personal pleasure – which I am not going to judge what you do with your money. You should live your life in a way that makes you happy. My only guidance is that you try and avoid borrowing money to fund these.
The emotional analysis
So all of the above was part of the financial analysis. But as I mentioned, debt is both a financial and emotional choice. You also need to do what allows you to sleep well at night. I have friends who despite the financial numbers saying otherwise will run a million miles away from debt. The thought of debt scares them completely. On the other hand, there are people who cannot stand the idea of buying anything with cash and believe debt gives them tremendous flexibility and they feel they can be responsible with it. Neither of them is wrong – personal finance is personal. So you do you – do what allows you to sleep well at night. But go with your eyes wide open and understand the financial implications well.
Concluding thoughts
You probably now understand why the answer to the question of whether debt is good or bad is ‘it depends’. There is a lot to unpack but for a lot of folks, they have already trained their brains to think through all this very quickly. So this is not a 20 hour decision filled with spreadsheets. Most often these can be quick decisions based on some rules of thumbs. Sometimes, putting the information on a spreadsheet can be helpful too.
I hope this article helped you think more strategically about debt. Thank you for reading and I wish you luck in your financial journey.
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
