“Some debts are fun when you’re acquiring them, but none are fun when you set about retiring them.” Ogden Nash
While some people believe that all debt is bad, I’m not one of them.
Most of the debts that the average person has are not the good kind and can knock you off the road to wealth so fast it’ll make your head spin.
It’ll be well worth your time to keep reading and gain clarity on how to tell the difference between good and bad debt, so you can avoid the kind that’ll hurt you. And if you already have bad debts, it’ll be much clearer to you why you need to get rid of them.
The three criteria that all good debt needs to meet
For debt to be good, it needs to meet ALL three of the following criteria:
- It makes you more money than what it costs you to have it.
- It has high odds of turning a profit.
- It’s money that you can afford to lose.
(If it only meets one, or even two of them, it’s bad debt.)
Here are some examples and details to illustrate what I mean.
- Re: It makes you more money than what it costs you to have it
A classic example of this is borrowing money at 2% interest to invest in something that makes you a 10% profit. After paying the 2% interest to the bank, plus any taxes you owe on your profit, you end up with more money than you started out with.
- Re: It has high odds of turning a profit.
Say you’re expecting to make a 10% profit with borrowed money by investing in the stock market. What are the odds of your prediction coming true? What are the odds of you losing all the money in the market and having to pay back the bank with your personal cash?
In many (if not most) cases, the risk involved doesn’t make the potential profits worth the costs of borrowing the money, so such a debt would not count as good debt.
Obviously, it’s a judgment call as to whether or not the odds of making a profit are any good. To make your predictions as accurate as possible, you should gather as much research as you can, run the numbers for various potential scenarios, and make your best call.
- Re: It’s money that you can afford to lose.
That is, you can afford to pay it off on your own even if you lose all the borrowed money that you tried to invest. Because if you can’t afford to pay off the debt on your own, you probably shouldn’t have it in the first place. This may sound overly strict, but if you take this into consideration the next time you consider signing up for some “good debt,” it can save you from a world of hurt if your investment doesn’t yield the expected profits, or worse, ends up losing all the money you borrowed.
So for the rest of this chapter, we’re going to look at debt using the above criteria to classify it as either good or bad debt.
Remember, good debt is borrowed money that’s making you more cash than the cost of carrying the debt, has dramatically good odds of making profits worth the risk of borrowing the money in the first place, and that you can pay off on your own if necessary (ex. if you lose all the borrowed money due to your investment going bad).
It is that simple.
The focus of this book is specifically about getting rid of bad debts. Because those are the ones that are mostly likely to get in your way on the road to wealth. They should be avoided if possible, and if you have them, you should consider the task of getting rid of them to be urgent.
On the flip side, in certain situations, good debt can be a useful tool for growing one’s wealth more quickly and might be worth the risk of taking on. But that’s a topic for another book. Please note that I said “in certain situations” and “might.” And I certainly am not suggesting that good debt is free of risk.
In any case, before I go on, let’s take a look at a couple of examples to make it clear what the differences are between good and bad debt.
An example of good debt
Because our criteria for good debt takes into account what you can afford to lose (and everyone will be different), there isn’t a one-size-fits-all rule. However, the example that follows will help you to see how we can evaluate debt to figure out if it’s good or bad.
And because it’s the details that make all the difference, those are included too.
Michael is 45 years old. He paid off his house, which is worth about $300,000 in today’s market. He rents out two spare bedrooms in his home to local college students, which earns him $12,000 per year.
He earns $36,000 a year from his pension. (Yes, he’s young to have a pension… but he had a job at the local jail that he started when he was 19 years old. After 25 years, he decided to take early retirement and collect his pension.)
He also works full-time mowing neighborhood lawns. He’s built up quite a large list of regular customers over the years and earns $48,000 a year doing that.
He’s single with no dependents. He’s in perfect health. He has solid insurance policies to cover him if he becomes unable to work due to a serious illness or disability.
Michael wants to bump up his retirement nest egg, so he buys a condo for $187,500 that’s in excellent condition to rent out. He puts a $37,500 down payment on the condo, leaving him with a $150,000 mortgage that’s scheduled to be paid off in 20 years. If he adds up his property taxes, home owner association fees, expected maintenance/repairs and mortgage payments, he’d need to bring in a minimum of $1650 per month to break even regarding cash flow.
Because this condo is in a high demand neighborhood with ridiculously low vacancy rates, he’s able to get $1650 per month in rent. His plan is to manage the property himself, and because he’s a handy guy, he can handle simple maintenance issues on his own.
Let’s assess his condo debt to see if it’s good or bad debt.
For this example, I’m going to calculate the return on his investment for the next five years only.
Please note that the best calculation would be for a long-term projection of what would happen if he owned this property for 20 years. The longer he holds onto this property, the greater his returns are likely to be since in the early years a very large percentage of his mortgage payment is going towards interest, whereas in the later years of his mortgage a larger percentage is going towards the principal. Additionally, holding on to the property long-term protects him from short-term fluctuations in value.
Anyhow, here we go.
In the first five years of ownership, an average of a little over $26,000 of the condo’s mortgage is going to be paid off. And since historically speaking, the rate of home price appreciation approximately matches the rate of inflation (if you take into account the increase in home sizes over the same period), I’m going to assume he makes nothing from appreciation.
Important note: For the record, I don’t advise you to invest in real estate if you only plan on keeping the property for five years. Due to the potential for short-term volatility in the market, you have greater odds of taking a horrible loss. On the flip side, if you buy with the intention of holding onto it for 20 years or more, the odds are extremely high that you’ll make a profit if you buy the right property. Of course, there’s a lot more to it than that — and there are too many details to go into here. But do keep this fact in mind.
Okay, so he put in $37,500 of his money (for the down payment), and not a penny more. The rent covered all other expenses. So the debt is paying for itself. (Criteria #1 for good debt is met.)
And say the housing market was flat, and the property value didn’t increase at all when considering inflation. Even then, he’d have made a good return on his investment. (Criteria #2 is met.)
Here are the quick and dirty calculations that allowed me to arrive at that conclusion.
[$26,000 (amount of mortgage paid off)/$37,500]100/5 years = 13% return on his investment per year.
This debt is making him more money than what it costs him to have it, the odds are good that it will continue to do, and worst case scenario he can afford to pay it off on his own without declaring bankruptcy.
Even if home prices fell by 50% a year after bought it, he couldn’t find a good tenant so was now missing out on rental income, and he wanted to get out, he could sell the condo and his house, pay off the mortgage, and be debt free. Poof. Just like that. Sure, it would stink to have to do that since he’d lose money, but if push came to shove, he could afford to pay off the debt on his own. (Criteria #3 for good debt.)
For the above reasons, I consider his mortgage on the rental condo to be good debt, and not as urgent to pay off.
Paying off bad debt, on the other hand, should always be considered an urgent matter. The very facts that it doesn’t pay for itself and doesn’t generate profits means you’re at greater risk of it someday causing you undo financial hardship compared to good debt.
Please note: After more urgent financial matters have been attended to, it’s worth considering paying off your good debts as soon as possible. Because the less debt you have, the less risk you’re exposed to.
Examples of bad debt
Michael’s friend Frank suggests that he buy a lakefront cabin in the woods to have a fun place to escape to on the weekends. This would require him to take out a 20-year mortgage for $300,000.
He says Michael deserves it, and the extra space would be nice.
The trouble is, Michael wouldn’t be making any money off it.
The interest rate being charged on the mortgage is 4%. Once again, since historically speaking, the rate of home price appreciation approximately matches the rate of inflation (if you take into account the increase in home sizes over the same period), I’m going to assume he makes nothing from appreciation. (If you want to nerd out with me doing the calculations that brought me to this conclusion, please check it out in the Appendix.)
Over the next five years, it’ll cost him $54,378 in interest payments
It’ll cost him a total of $17,500 in property taxes ($3500/year x 5 years).
And he figures that he’d spend about $7,500 in maintenance and repairs ($1500/year x 5 years).
If he sells in five years, he’ll have spent a total of $79,378 to own it (i.e. $54,378 in interest payments, $17,500 for property taxes, and $7,500 for maintenance/repairs).
Or, to put it another way, assuming he sells it in five years, it would have burned through about $3307 per month that he’ll never get back.
Is that worth it? Probably not, unless he can afford to burn that much money a month on a vacation home, and plans on spending more than $3307 every single month for five years renting vacation homes on his weekends off (in which case is buying it might save him some money).
Remember, historically speaking, if you hold onto a piece of real estate for a long period and take into account inflation, real estate doesn’t make you a return on your investment via appreciation. Sure, you can get lucky and make money via appreciation via short-term volatility in the market if it works in your favor, but it would be irresponsible to depend on appreciation as the primary way of making money via real estate whether it be your family home or an investment property.
All that being said, if he holds onto the property for longer than five years, his average monthly interest cost will go down with time (because the longer you make payments on a mortgage, the lower the percentage of your payment that goes towards interest). Ultimately, the only way to know for sure if it’s “worth it” to buy will depend on Michael’s preferences and how long he plans on keeping it. But for anyone who holds onto such a vacation home short term, as you saw, it’s often not worth it at all.
Intelligence upgrade from following the herd?
Sometimes following the herd is a good thing. It saves us the time of figuring out what to do on our own. We use the wisdom of the crowd to our benefit. It can provide us with an intelligence upgrade because we can base our decisions on the pooled knowledge of the group as a whole, rather than just our own relatively small slice of it.
But other times, it doesn’t work out so great. Not just for us mere mortals, but for animals too.
The Daily Mail reported on the case of 28 cows that, possibly spooked by thunderstorms, ran off a cliff one after the other and died.
USA Today reported the baffling case of almost 2000 sheep in Turkey who did the same thing. The first 450 to jump ended up dead.
Can you imagine such a thing? It’s insanity!
I bet those animals regretted following the herd the second they hit bottom.
We like to think that as humans, we’re smarter than that. But sometimes our human herd makes the wrong call too.
And unfortunately, many members of our herd are big time into credit card debt.