I have on multiple occasions underscored the importance of living a debt-free life. However, such an ideal life is elusive for many owing to the precarious times we live in where incurring debt can be inevitable. After all, even most of the reputable businesses in existence today once took out loans (debts) to build their brands. The whole idea of debt which entails owing someone sounds so negative especially considering the stress and tension it can involve. However, it’s quite possible to categorize debt as either good debt or bad debt. The differences aren’t clear-cut black and white as you’ll see in this article – there are subtleties and grey areas
The Argument For Debt Inevitability
So you already know my position on debt – I prefer that one ever gets into debt. Noble as that is but there is a school of thought that argues that debt is inevitable. Ideally, they base their position on the mantra that money begets money. So if debt is inevitable in that regard then a clear delineation between what constitutes good or bad debt is crucial to decision-making.
Debt To Income Ratio
Your current financial position prior to incurring debt is the indicator of whether or not the debt you are about to get into is good or bad. Here is the thing, if you have no prior debts then there is room for the subsequent debt being good (provided it adheres to other points I’ll elaborate further on in this article). If you have pre-existing monthly debt payments then add them up and express them as a ratio of your total monthly income. As a rule of thumb it’s normally suggested that that ratio mustn’t exceed 40%. Why you may ask? This will ensure you that you can still cater for your fixed monthly costs and are also well-prepared for any incidentals despite servicing debts. So if your current debt to income ratio is over 40% then any further debt taken out will be considered bad debt.
Value & Income Generation
A good debt entails borrowing money to purchase something that’ll create value and generate income over time. Whilst bad debt connotes borrowing money for the purchase of something whose value quickly depletes over time and doesn’t appreciate any value or income. Examples of good loans are academic loans or mortgages which are both things that either earn income in the future or appreciate in value over time. Bad debt usually involves borrowing money to purchase liabilities such as cars, clothes, accessories and so on.
Context Affects Categorization
I earlier on alluded to the existence of grey areas, my previous point I indicated that a car is a liability and borrowing to buy such is bad debt. However, the context can change that whole perspective. Suppose you borrow money to buy a car that will be used for delivery purposes for your business – that becomes labelled as good debt. This is because you’ll be using the car for the purposes of creating value and generating income. Conversely, if you borrow money to buy a luxury car then that can be bad debt but if you are to rent or hire it out that becomes good debt. So I’m sure you get the dynamics of how the context can determine whether or not the debt is good or bad.
Interest Rates & Repayment Periods
Good debts usually have low-interest rates and are payable over extended periods of time in small, manageable instalments. Bad debts are usually characterised by very high-interest rates (which can be mercurial i.e. changing over time) and are normally payable over very short periods of time. This actually leads to scenarios where the debt can’t even be repaid at all. So when considering debt this is called the matching principle which simply put states that you cannot finance long term projects with short term finance.
The 3 Things To Look At Before Getting Into Debt
Suppose you reach the crossroads and you’re contemplating getting into debt; that can happen to anyone. Here are 3 things you must carefully consider before taking that step:
Remember I mentioned the debt to income ratio earlier which indicates that the income factor is important. Your current income stream(s) or any subsequent income stream(s) enacted by the purposes for which the debt is incurred must make debt repayment easy. By easy I’m referring to still being able to live sustainably whilst effectively serving your debt repayments. If you can’t see this happening then chances are you’ll struggle to handle the debt meaning you can’t afford it.
Is the debt going to lead to value creation and the generation of income over time? The ultimate value and income generated must far outweigh the initial debt incurred. If projections point to these issues then go ahead and borrow the money – it’s good debt.
Failure to repay debt can result in painful legal action being taken against you. Will you be able to pay back the debt in time i.e. can any unforeseen circumstances stifle you from doing so? Is the pain and sacrifice you’ll endure in handling the debt worth it? These are some of the questions you should ask yourself. Honestly, assess the risk factor before settling for debt.
I’ll say this again; not being in debt is most advisable especially in a highly volatile environment like ours. Regardless, if you closely consider all that I have discussed in this article you can still avoid bad debt and only incur good debt. Truth is at times overly shunning debt can rob you of opportunities that you can successfully embark on by following principles of good debt. So, now you have the information, the choice is yours.