Bad debt versus Good debt – value for debt not value for money

Not all debt is created equal.

I’ve been holding off on writing about this debate for a long time. Part of me wanted to ignore it and lump all debt into the bad category. Another part of me wanted to fight the corner of good debt. Given that debt is such an emotionally charged issue there was always going to be a conflict for me. Some days I can see the argument in favour of good debt clearly other days all debt is bad to me.

So anyway here goes.

Bad debt is a confusing idea. Most of us will have heard the term used in conjunction with a bank or business. Something along the lines of “bad debts are running at 5% of the loan book”, what bad debt means in this context is simply that some of the loans the bank or business has made have gone bad. The people that they have lent the money to are no longer in a position to pay the loan back.

On a personal finance level bad debt can be considered any debt that you personally take on that costs you money. But doesn’t all debt cost me money? Well yes it does but not all debt is the same.

It’s best to give an example.

To me bad debt would be buying something like a holiday on credit. Say I went on a holiday that cost me $1000 and I paid $100 for 12 months to pay it off. To me that debt is bad because I am still paying off the cost of the holiday one year after I have taken it and there is a large interest charge. It creates a big hole in my personal Profit and Loss and Balance sheet. Here I have a big monthly expense that I have to pay for every single month and yet I have absolutely nothing to show for it.

I think you can see where this is going.

Bad debt versus Good Debt – it is all about value

I want to clearly outline the idea here so please bear with me.

You may have read in various financial books that good debt can simply be thought of as a debt that allows you to generate a positive cash flow. The typical example given is a rental property where the monthly cost of repaying the mortgage is less than the rental revenue which is received, thereby creating a positive cash flow for owner of the property. I agree with this definition 100% but I want to expand it.

You see the definition outlined about is too narrowly focused. It is based on a purely financial logic based calculation – but life and debt is never ever that simple. I like to think about debt as relative to the value it adds to you, to your life, your education and yeah sure, to your bottom line.

I never stick to the cold hard logic that debt is either good or bad based simply on cash flow. It makes finance too cut and dry…and boring. The question that you have to ask yourself is whether or not the debt that you are taking on will add value in your life?

Is debt from financing a college education good or bad debt
In my mind it is good debt.

Is signing up for a pay monthly gym membership good or bad debt? If you use the gym often then it is a good debt. If you only use the gym only once then the debt is bad.

Is taking a loan out to buy a car a good or bad debt?
Well that depends – can you get the bus? Can you buy a cheaper model? What do you need the car for? Will the car add value to your life?

One key assumption that underpins my way of thinking about debt is whether or not I can afford the repayments. I am working on the assumption that when I consider a debt that I can afford the repayments. If I can’t afford to make the repayments in the long term then there is no point even thinking about taking on the debt because it is a bad idea – EVEN if it will add value to your life.

My idea of good debt is open to abuse

You see debt is all about personal choice and personal responsibility. Some people might take what I am saying about debt being good if it adds value to your life and distort it. Some people might say something like “well this 60inch plasma screen will certainly add value to my life because I will be able to enjoy a better quality of entertainment” or “This holiday will make me feel better and therefore add value to my life”.

It doesn’t work that way and common sense is called for. You have to be critical in your thinking when it comes to debt. When approaching a decision it is necessary to have all the facts but that is not enough. You need to be honest with yourself. At the end of the day it is you that will have to be carrying the debt so you need to make sure that you are getting good value for it and not wasting it on frivolous items.

Critical thinking

I touched on this briefly above. If you are to adopt the value based idea about debt (I’m not saying that you should only that you be open to new ideas) then I think that you should err on the side of caution. Go into each decision about debt with a slightly negative expectation and add a large drop of cynicism for good measure.

Don’t look for reasons as to why the additional debt will add value to your life. Instead look for reasons why you should avoid that additional debt at all or at least reduce the amount you take on.

If, after running the decision to take on the debt through a number of value add calculations, you still decide to take on the debt then you can be happy in the knowledge that the debt you are taking on should add value to your life in the long run.

Investing in yourself

I suppose what I’ve outlined above can simply be termed as ‘investing in yourself’. Ultimately it is the best investment that you can ever make. Over the long term the return (both financial and otherwise) that you achieve from something like a college education or better fitness will far outweigh the cost of your debt.

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