Good debt vs bad debt, what's the difference?
Not all debt is to be studiously avoided. Here's how to know if you're taking on the good kind.
Debt is a four letter word and, in many cases, deserving of its reputation. However, there's ‘bad debt' and ‘good debt'. One can speed up your path to financial freedom, while the other can ruin your chances just as quickly.
The easiest way to tell whether you have good or bad debt has nothing to do with the debt itself and everything to do with what you spend it on.
Borrowing money to buy goods and services is generally bad (though there are some exceptions, which we'll get to in a moment). Using credit cards or a personal loan to splurge on a new TV, clothes, or a car is a bad idea because these things lose their value. You don't want to lose even more money by paying interest. If you borrow money to bring forward consumption – so that you don't have to save – those debts fall squarely in the rotten camp.
Using debt to buy assets, however, can sometimes make a lot of sense. Productive assets tend to grow in value and generate an income for you. The two main productive asset classes are stocks and property, but a third is your education. Borrowing money to get a university degree or to do an apprentiship is usually fine, but it's important to consider whether the education has a strong chance of improving your future income. Getting a loan to do finger painting classes doesn't count.
High vs low interest
Good debts require low interest payments, bad debts have high interest. It's as simple as that. Unsecured personal loans, credit cards, and … the worst of the worst … payday loans, are all considered bad debts because you'll probably stay in the red even if you use them to buy productive assets.
If you have any high-interest debts, paying these off should be your top priority. Paying off a credit card that charges 20% in interest is the same as getting a 20% return on your savings – or more, given taxes – which would be hard to match even by investing in stocks or property.
Some low-interest debts may be worth keeping, though. For example, a HECS-HELP student loan charges no interest and has no fixed term. It's probably the best loan you will ever get. There's a case for keeping this debt for as long as possible and making only the compulsory repayments, so you can invest the capital in higher-yielding assets.
Getting a prime mortgage to buy a home can also be done guilt-free, so long as you don't overstretch your income when deciding how much to borrow and you don't overpay for the house. Property has grown more slowly than the sharemarket over the long term but, because most people borrow to buy a home, their equity is able to grow faster than the underlying house price growth.
It seems counterintuitive, but even using a low-interest loan to buy a depreciating asset can sometimes make sense. I faced this conundrum recently when buying a new car: should I pay cash or get an auto loan at 5%?
If you have no assets, then getting a car loan is a terrible idea. However, I have a portfolio of stocks and over the long term the sharemarket has returned around 9% a year (call it 7.5% after tax). Getting a loan at 5% to buy a car makes more sense than selling an asset that yields 7.5% to buy it. When deciding whether to get a loan – or to pay one off – always consider your opportunity costs if you own productive assets.
Good terms vs bad terms
Investors often get into trouble by ticking the first two boxes – buying a productive asset with low-interest debt – but not reading the terms and conditions.
Short-term loans or those where the lender has a right to sell your assets without first notifying you (think margin loans and CFDs) can lock in losses at exactly the wrong time. These loans remove one of the key advantages you have as an investor – a long-term horizon with the ability to weather short-term volatility.
Furthermore, even if you're using a safer form of leverage to purchase an asset, it's still important that you maintain some easily accessible cash to act as a buffer should any unexpected expenses arrive. The absence of a cash buffer could put you in a position where you rack up even more costly debt or overdraft fees if you run into trouble, such as the loss of your job.
A good rule of thumb is to have enough savings to cover at least 3–6 months' worth of living expenses, and never invest money in the stock market that you may need to access within the next five years. Park your emergency money in a high-interest savings account or, even better, a mortgage offset account because the interest saved is likely to exceed the income earned elsewhere.
Using long-term debt with a low interest rate and favourable terms to buy productive assets can add a little fertilizer to your portfolio. However, even good debt generally has a downside – so don't add too much, and watch out for the weeds.
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