First of all, debt is a tool of financial management. It adds financial risk because of interest and principal payments you make to the lender. However, not all debt is harmful. Sometimes, it can improve your financial situation.
A simple litmus test can be applied to whether you should take on a loan.
1. Are you buying an appreciating asset?
2. Are you buying an asset that has an income stream?
3. Is this debt going to increase your current income stream?
4. Is this debt used to support your well being and health?
Classes of Good Debt
The above are the reasons why anyone should acquire debt. Of course, there are extenuating circumstances such as a relative going to the hospital. But the common motif in these circumstances is that you will be in a better financial situation AFTER taking out the loan.
1. Appreciating Assets
Appreciating assets are those that increase in value over time. To take a look at how the math works, let’s use real estate.
Historically, housing prices have gone up 3-4% every year. When you take out a loan to buy property, you generally pay 20% down.
(1) Let’s say you purchase a home for $100K, with $20K cash and an $80K loan.
(2) Assume 4% appreciation every year; the same home will be worth about $120K in 5 years.
(3) You sell it at year 5 for $120K and pay back the $80K loan.
(4) Your total profit will be $40K on a $20K cash investment.
(5) Congratulations! You doubled your money in 5 years.
2. Assets with Income Streams
Loans used to buy assets with income streams are almost always a good investment. The cash flow produced offsets the loan interest and principal payments. Here are some examples below:
(1) Rental properties
(3) Internet assets that have traffic and ad revenue
(4) Private equity
This is the whole premise of private equity. You are using your own money and then borrow the rest from a bank to buy an already profitable business. You then improve it and sell it within a few years.
3. Assets that Increase Your Current Income Streams
Loans used to improve your earnings potential can also be good debt. Capex and student loans are good examples.
At the PE firm I work for, we recently acquired a company that manufactures snacks sold to retailers across the country (think Walmart, Kroger, and Aldi). However, demand was so great that we had to take out a loan to acquire more machinery to increase our production capacity.
A more recent experience is my sister going to medical school. It costs $40K a year; most of it will be financed with loans. However, the earning potential for doctors is well worth the loan!
4. Your Wellbeing and Health
Of all the important things in life, I learned over the years that health is the most important (even above money and status). If it means taking on debt for a gym membership to improve your well being, go for it. After all, better physical fitness can only improve your financial health.
Taking on Too much Debt
When you take on too much debt, more of your present income will be dedicated to servicing the principal and interest. The question you must ask is whether your income or the income of your business is sufficient to service the interest and principal payments.
For instance, taking out a loan to buy your first home is generally a good thing. However, if you are buying a house for $1 million, and then committing ½ your income to paying the mortgage every month, then you are in trouble!
Bad debt is everything that does not improve your financial situation. Credit card debt, vacation debt, and expensive auto loans are common examples. These things do not really generate any new income and are a burden on being financial free.