Knowing the Difference between Bad Debt and Good Debt
Why do you borrow money? Usually, you borrow money because you don’t have enough to buy something you want or need — like a college education. A four-year college education can easily cost $100,000, $150,000, $200,000, $250,000, or more. Most people don’t have that kind of spare cash. So borrowing money to finance part of that cost enables you to buy the education.
How about a new car? A trip to your friendly local car dealer shows you that a new set of wheels will set you back $25,000+. Although more people may have the money to pay for that than, say, the college education, what if you don’t? Should you finance the car the way you finance the education?
The auto dealers and bankers who are eager to make you an auto loan say that you deserve and can afford to drive a nice, new car, and they tell you to borrow away (or lease, which I don’t love either — please see. I say, “No! No! No!” Why do I disagree with the auto dealers and lenders? For starters, I’m not trying to sell you a car or loan from which I derive a profit! More importantly, there’s a big difference between borrowing for something that represents a long-term investment and borrowing for short-term consumption.
If you spend, say, $1,500 on a vacation, the money is gone. Poof! You may have fond memories and photos, but you have nothing of financial value to show for it. “But,” you say, “vacations replenish my soul and make me more productive when I return … the vacation more than pays for itself!”
I’m not saying that you shouldn’t take a vacation. By all means, take one, two, three, or as many vacations and trips as you can afford yearly. But the point is to take what you can afford. If you have to borrow money in the form of an outstanding balance on your credit card for many months in order to take the vacation, then you can’t afford it.
Getting your way in to bad debt
I coined the term bad debt to refer to debt incurred for consumption because such debt is harmful to your long-term financial health. (I used this term back in the early 1990s when the first edition of this book was published, and I’m flattered that others have since used the same terminology.)
You’ll be able to take many more vacations during your lifetime if you save the cash in advance. If you get into the habit of borrowing and paying all the associated interest for vacations, cars, clothing, and other consumer items, you’ll spend more of your future income paying back the debt and interest, leaving you with less money for your other goals. The relatively high-interest rates that banks and other lenders charge for bad (consumer) debt is one of the reasons you’re less able to save money when using such debt. Not only does money borrowed through credit cards, auto loans, and other types of consumer loans carry a relatively high interest rate, but it also isn’t tax-deductible.
I’m not saying that you should never borrow money and that all debt is bad. Good debt, such as that used to buy real estate and small businesses, is generally available at lower interest rates than bad debt and is usually tax-deductible. If well managed, these investments may also increase in value. Borrowing to pay for educational expenses can also make sense. Education is generally a good long-term investment because it can increase your earning potential. And student loan interest is tax-deductible, subject to certain limitations . Taking out good debt, however, should be done in proper moderation and for acquiring quality assets. See the section later in this chapter, “Assessing good debt: Can you get too much?”
Recognizing bad debt overload
Calculating how much debt you have relative to your annual income is a useful way to size up your debt load. Ignore, for now, good debt — the loans you may owe on real estate, a business, an education, and so on (I get to that in the next section). I’m focusing on bad debt, the higher-interest debt used to buy items that depreciate in value. To calculate your bad debt danger ratio, divide your bad debt by your annual income. For example, suppose you earn $40,000 per year. Between your credit cards and an auto loan, you have $20,000 of debt. In this case, your bad debt represents 50 percent of your annual income.
The financially healthy amount of bad debt is zero. While enjoying the convenience of credit cards, never buy anything with your credit card(s) that you can’t afford to pay off in full when the bill comes at the end of the month. Not everyone agrees with me. One major U.S. credit-card company says — in its “educational” materials, which it “donates” to schools to teach students about supposedly sound financial management — that carrying consumer debt amounting to 10 to 20 percent of your annual income is just fine.
When your bad debt danger ratio starts to push beyond 25 percent, it can spell real trouble. Such high levels of high-interest consumer debt on credit cards and auto loans grow like cancer. The growth of the debt can snowball and get out of control unless something significant intervenes. If you have consumer debt beyond 25 percent of your annual income.
How much good debt is acceptable? The answer varies. The key question is: Are you able to save sufficiently to accomplish your goals? In the “Analyzing Your Savings” section later in this chapter, I help you figure out how much you’re actually saving.
Remember Borrow money only for investments (good debt) — for purchasing things that retain and hopefully increase in value over the long term, such as an education, real estate, or your own business. Don’t borrow money for consumption (bad debt) — for spending on things that decrease in value and eventually become financially worthless, such as cars, clothing, vacations, and so on.
THE LURE OF EASY CREDIT
Many years ago, I worked as a management consultant and did a lot of work with companies in the financial services industry, including some of the major credit-card companies. Their game then, as it is now, was to push cards into the hands of as many people as possible who have a tendency and propensity to carry debt month to month at high interest rates. Their direct marketing campaigns are quite effective. Ditto for the auto manufacturers who successfully entice many people who can’t really afford to spend $20,000, $30,000, $40,000, or more on a brand-new car to buy new autos financed with an auto loan or lease.
And just as alcohol and cigarette makers target young people with their advertising, credit-card companies are recruiting and grooming the next generation of overspenders on college campuses. Unbelievably, our highest institutions of learning receive substantial fees from credit-card companies for allowing them to promote their cards on campuses!
As widely available as credit is today, so, too, are suggestions for how to spend it. We’re bombarded with ads 24/7 on radio, TV, websites, blogs, cellphones, the sides of buses and trains and the tops of taxicabs, people’s clothing, and cars. You couldn’t go a day without being exposed to advertising if you wanted to — you’re surrounded!
Assessing good debt: Can you get too much?
As with good food, you can get too much of a good thing, including good debt! When you incur debt for investment purposes — to buy real estate, for small business, even your education — you hope to see a positive return on your invested dollars.
But some real-estate investments don’t work out. Some small businesses crash and burn, and some educational degrees and programs don’t help in the way that some people hope they will.
There’s no magic formula for determining when you have too much “good debt.” In extreme cases, I’ve seen entrepreneurs, for example, borrow up to their eyeballs to get a business off the ground. Sometimes this works, and they end up financially rewarded, but in most cases, extreme borrowing doesn’t.
Here are three important questions to ponder and discuss with your loved ones about the seemingly “good debt” you’re taking on: Are you and your loved ones able to sleep well at night and function well during the day, free from great worry about how you’re going to meet next month’s expenses?
Playing the credit-card float
Given what I have to say about the vagaries of consumer debt, you may think that I’m always against using credit cards. Actually, I have credit cards, and I use them — but I pay my balance in full each month. Besides the convenience credit cards offer me — in not having to carry around other forms of payment such as extra cash and checks — I receive another benefit: I have free use of the bank’s money until the time the bill is due. (Some cards offer other benefits, such as frequent flyer miles or other rewards, and I have those types of cards too. Also, purchases made on credit cards may be contested if the sellers of products or services don’t stand behind what they sell.)
When you charge on a credit card that does not have an outstanding balance carried over from the prior month, you typically have several weeks (known as the grace period) from the date of the charge to the time when you must pay your bill. This is called playing the float. Had you paid for this purchase by cash or check, you would have had to shell out your money sooner. If you have difficulty saving money and plastic tends to break your budget, forget the float and reward games. You’re better off not using credit cards. The same applies to those who pay their bills in full but spend more because it’s so easy to do so with a piece of plastic.
Analyzing Your Savings
How much money have you actually saved in the past year? By that I mean the amount of new money you’ve added to your nest egg, stash, or whatever you like to call it.
Most people don’t know or have only a vague idea of the rate at which they’re saving money. The answer may sober, terrify, or pleasantly surprise you. In order to calculate your savings over the past year, you need to calculate your net worth as of today and as of one year ago.
The amount you actually saved over the past year is equal to the change in your net worth over the past year — in other words, your net worth today minus your net worth from one year ago. I know it may be a pain to find statements showing what your investments were worth a year ago, but bear with me: It’s a useful exercise.
If you own your home, ignore this in the calculations. (However, you can consider the extra payments you make to pay off your mortgage principal faster as new savings.) And don’t include personal property and consumer goods, such as your car, computer, clothing, and so on, with your assets. (See the earlier section “Determining Your Financial Net Worth” if you need more help with this task.) When you have your net worth figures from both years, . If you’re anticipating the exercise and are already subtracting your net worth of a year ago from what it is today in order to determine your rate of savings, your instincts are correct, but the exercise isn’t quite that simple. Why? Well, counting the appreciation of the investments you’ve owned over the past year as savings wouldn’t be fair. Suppose you bought 100 shares of a stock a year ago at $17 per share, and now the value is at $34 per share. Your investment increased in value by $1,700 during the past year. Although you’d be the envy of your friends at the next party if you casually mentioned your investments, the $1,700 of increased value is not “savings.” Instead, it represents appreciation on your investments, so you must remove this appreciation from the calculations. (Just so you know, I’m not unfairly penalizing you for your shrewd investments — you also get to add back the decline in value of your less-successful investments.)
Your Savings Rate over the Past Year
If all this calculating gives you a headache, you get stuck, or you just hate crunching numbers, try the intuitive, seat-of-the-pants approach: Save a regular portion of your monthly income. You can save it in a separate savings or retirement account.
How much do you save in a typical month? Get out the statements for accounts you contribute to or save money in monthly. It doesn’t matter if you’re saving money in a retirement account that you can’t access — money is money.
Note: If you save, say, $200 per month for a few months, and then you spend it all on auto repairs, you’re not really saving. If you contributed $5,000 to an individual retirement account (IRA), for example, but you depleted money that you had from long ago (in other words, money that wasn’t saved during the past year), don’t count the $5,000 IRA contribution as new savings.
Save at least 5 to 10 percent of your annual income for longer-term financial goals such as retirement