Most people are taught that lending money is something bad. Preferably everyone would want to buy their home without a mortgage, this is seen as something 'good'. Credit card debt is seen as 'bad' and preferably no one wants a student loan. Is it true that al debt is bad? Is it smart to pay everything from your own pockets?
'Good Debt' and 'Bad Debt'
The world of finance distinguishes 'Good Debt' from 'Bad Debt'. The difference between good and bad debt are between the function of the debt. A general rule to keep in mind is the following:
If the chance is big that you will financially improve after taking on the debt, it is a 'good debt'. If the chance is very big you will financially loose money because of taking on the debt, it is a 'bad debt'.
Another rule which you could also keep in mind when determining whether something is a good or bad debt is:
If you try to make money with the debt to pay your loan back it is a 'good debt'.
3 Examples to Practice With
I will give you 3 examples where you can decide for yourself whether this is a good debt or a bad debt.
Situation 1
Lauren gets her salary in 3 days and only has $ 20 left on her bankaccount. She looks online and sees an advertisement about the new Harry Potter Hogwarts Legacy game which she can pre-order for Christmas. The game is $ 60 and she decides to pre-order the game. She pays with her credit card and her bankaccount is negative $ 40 for 3 days.
You now have 1 minute to decide whether this is a good debt or a bad debt and why you think that..
Short answer: The rule is: if you will probably lose financial value because of the loan, it is 'bad debt'. In this case Lauren doesn't invest in something financially worthy, so this can be labeled as a bad debt.
Comprehensive answer: A loan at a credit card is between the 12% and 14% on a yearly basis. We will now calculate with a rent of 13%. In Laurens situation she has lend $ 40 for 3 days which has a total rent cost of about $ 0,04 ($ 40 x (3/365) x 0,13). Besides, the game will make her financial situation worse by decreasing in value. This loan will in total decrease her total financial value by at least the $ 0,04 of the loan costs + the decrease in the game value.
Do you want to try another one? This one is more difficult...
Situation 2
Rox wants to buy shares and has $ 1000 to invest. He sees videos and ads about how lending money creates the 'leverage effect' which could gain him an extra high ROI. He decides to take on a lot of risk and finances his shares for 50% with debt. He buys $ 2000 worth of 100% Apple shares (50% own money, 50% debt). The debt has an interest cost of 6% per year.
After 30 days the shares of Apple have increased with 20% and his shares are now worth $ 2400. He decides to sell his shares.
In this situation you will have 2 minutes to decide whether this is a 'good debt' or a 'bad debt' and why..
Short answer: The aim of Rox is to lend the money to make a profit and increase his overall wealth. According to the rules we learned, this means the debt is a good debt. On the other hand, Rox does this in a very risky way. Firstly, he puts all his money in 1 stock. Secondly, it is very risky to lend money for investing in shares, because shares are very volatile.
At first sight it is thus a good debt, but it could easily have resulted in a bad decision when the shares would have decreased. Personally I would thus not classify this as a 'good debt'. Look at the comprehensive answer for the mathematical differences between the profits with and without the loan ;).
Comprehensive answer: To decide whether Rox is financially better off we will compare two situations: one without the loan and one with the loan.
If Rox had bought the Apple shares for $ 1000 with 100% own equity, his profit would have been $ 200 after 30 days (0,20 x 1000) if he sold the shares.
In the situation where Rox bought $ 2000 on shares where 50% is a loan, the costs of the loan were $ 5 (0,06 x 1000 x (1/12)). The shares has risen to with a value of $ 400 and Rox keeps $ 395 as a profit.
When comparing these two situations it is clear that Rox is financially better of with the loan. In this case the 'good debt' turned out wel. If the shares had declined, Rox had a big problem.
One more then... ;)
Situation 3
Mick has saved up $ 30,000 to buy a house he wants to rent out. He fills out an online survey and can lend $ 170,000 for 30 years with an annual rent of 5%. He decides to buy a home worth $ 200,000 and rents out the house for $ 1,100 per month.
Take 1 minute to think about this one...
Short answer: In this case Mick tries to increase his total wealth by paying off the loan with the rent of the tenant. It is still risky, but a lot less risky than situation 2. The value of the house will most of the time stay the same or will increase and besides that you are almost sure of a monthly income to pay the mortgage. This is, as you probably guessed, thus a good debt.
Comprehensive answer: Another mathematical example for the real diehards ;). Mick pays $ 11,059 per year for his annuity mortgage which is about $ 922 per month (you can calculate this by putting this formula in Excel: PMT(0,05;30;-170,000). He collects a rent of $ 1,100 per month which means he will save $ 178 per month. 178/1100 is 0,5% ROI per month and about 7,12% on a yearly basis.
If Mick bought the house only with his own money, $ 200,000, the profit would have been $ 1,100 per month. No costs are made because Mick doesn't have to pay for a mortgage. $1,100/$200,000 = 0,5% per month and 6,6% on a yearly basis.
In this case the mortgage helps Mick to have a higher ROI. This is an example of the 'leverage effect'.
Disclaimer: In real life more costs will occur for the owner such as maintenance costs. In this example it is not used because of simplicity.
Do you get it?
Overall, loans are not by definition bad and could help you to improve your financial situation. One thing to keep in mind is that loans are always more risky than investing with your own money, because you make a promise to pay the money back to someone.
Do you want to know more about real estate, investing and studying? Take a look at the other blogs and leave a like or a comment with your thoughts about good debt and bad debt :).