Good vs Evil (Debt)
In some investing circles, debt is a four-letter word. But it can't always be avoided, and some debt can actually be helpful. So let's look at some bad types of debt and good types of debt.
The elephant in the bad debt room is credit card debt. The primary reason is the amount of interest you must pay on outstanding balances, often in the 20-30 % range. At that rate, it is not difficult to find yourself in financial trouble very quickly. It doesn't make sense to invest S1000 in the stock market earning 10% if you have $ 5000 in credit card balances that are costing you 25%. So, work hard to pay off those balances and make it a habit to pay off your monthly statement.
There are other types of bad debt: payday loans, car title loans, or loan sharks (who are called sharks for a reason). All of these have oversized interest payments, some even higher than credit cards. Try to avoid anything in this category.
OK, what about good debt? Well, let's start with credit cards. Wait a minute... I know, I just said it was bad. Credit cards are a financial tool. If you paid for everything in cash, as soon as you buy something, that money leaves your accounts and goes to the merchant. If you pay with a credit card, the merchant is paid, but the money sits in your account earning interest until the due date on your next Statement. So the company is giving you credit for free up to that due date. That statement balance is debt but if you pay it all by the due date, it costs you zero, and you gain some interest. Free is good.
In addition, if you make timely payments on your credit cards, your credit score goes up. This tells other lenders (Car loans, mortgages, etc.) that you are less of a credit risk, which can also earn you better interest rates from those lenders. For instance, with a decent credit score, you might qualify for one of those year end 0% deals on your next vehicle.
A car loan with a low interest rate can also be good debt within limits. Making the payments raises your credit standing. Just be sure the payment is within your budget. If you have to leave balances on your credit card because your car payment is too high ... well, we've covered the problem with credit card balances.
Similarly, mortgages can be good debt, similar to car loans, with one major difference. Generally, your vehicle depreciates, or loses some of its value, as soon as you drive it off the dealer's lot or take delivery. Homes, on the other hand, tend to appreciate, or gain in value, over time. Home ownership and mortgages are an entire topic of their own.
If you buy a home for $250,000 in cash, you have no mortgage, but all of your money is tied up in the home’s equity or value on the market. Another option is to put down a down payment of $25,000 (or whatever number gets you down to a mortgage payment in your budget) and invest the rest. You now have a mortgage payment every month at 5% (for instance), but the bulk of your money is working for you as an investment, hopefully earning 9-10% on average. Theoretically, you are coming out ahead and also improving your creditworthiness.
In summary, while it is many people’s goal to get debt-free, debt should be just a tool in our financial toolbox. We just have to be conscious of what type of debt we have and how much it is really costing us. It is not really good or evil, but something we need to ensure is working for us and not getting out of control.
