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“I will never borrow money from someone else. I just hate that feeling”. Dealing with debt is always a big struggle and evokes many different, mostly negative emotions. Here is an explanation of whether these emotions are justified, here is an introduction to debt.
Everyone has heard of a story where someone’s financial life completely derailed and they were stuck neck-deep in debt, with no way out. We are all scared of becoming that person involuntarily. Well, at least I am.
Debt has many negative connotations for me. I do not like the feeling of having money or assets which do not fully belong to me. I guess my brain is sub-consciously afraid that someone would pop up out of nowhere and snatch away my money in case I had debts.
To alleviate these fears, I set out to find out more about debt. The overall goal of this post is to find out what the most common types of debt are and what the difference is between good debt and bad debt.
What is debt?
“Debt – something, especially money, that is owed to someone else, or the state of owing something” – Cambridge Dictionary.
Not much more needs to be defined as it relates to debt. If you owe someone something, then you are in debt.
From a financial independence point of view it is important to note that debt has an effect on your net worth. Remember how your net worth is calculated?
Net Worth = Assets – Liabilities
In financial terms, liabilities is a different word for debt. This means, the higher your debt is, the lower your net worth will be from a purely mathematical point of view.
What are the basic characteristics of debt?
When looking at debt there are three basic characteristics you need to be aware of:
- The maturity is the length of the debt, meaning until when the debt has to be paid off. For example, you might take a loan of CHF 10’000 which will be due in three years. The maturity of this loan is therefore three years.
- An interest rate is the cost of the debt. Extending on the example above, if the interest rate on the CHF 10’000 loan is 3% per year, then every year you will have to pay CHF 300 to the issuer of the loan. This is in addition to repaying the full CHF 10’000 at the end of the three-year period.
- The debt type can be either a revolving debt or a fixed instalment debt. Credit cards are a type of revolving debt, where you are able to loan as much money as you want until a certain limit. You just pay interest on everything you borrowed.
Fixed instalment means that there is a pre-defined schedule of how to pay off this debt. A mortgage which has a 30-year maturity would be such an example.
The Key Question: What is Good Debt? What is Bad Debt?
To make it simple and define what represents good debt, let’s go back to the original definition of net worth:
Net Worth = Assets – Liabilities.
If we take the assumption that our goal is to increase our net worth, then good debt is the kind of debt which helps us increase our assets beyond the liabilities we create in taking on debt.
Good debt increases our net worth. Bad debt decreases our net worth.
Let’s walk through a couple of examples of debt to better understand what is meant by this.
Types of Debt
For many people, mortgages are the typical example of good debt. Why? Because you are taking on debt in order to buy an asset with value.
A house has a value when you buy and it might appreciate. Any appreciation would increase your net worth, while keeping the debt level constant. Of course it might depreciate, but never to a level where it is not worth anything anymore.
Also, in Switzerland you can deduct your interest payments on your mortgage from taxes. Plus, you do not have to pay any rent. Both help you in reducing your expenses and increasing your assets.
If you have ever talked with an American about education, then you know that many Americans consider student loans the only way to get a good education. Many private universities in the USA cost a lot, to a level where I have heard of people exit university with over CHF 500’000 in student debt.
The typical reasoning is the following:
“I take on a large amount of debt now to get the best education I possibly can. This will then help me get a job with a super duper high salary. With this I can then pay off my student loans.”
I will not discuss the pros and cons of this approach in this post. What is important to realize is that taking out debt for educational sake can be considered good debt.
1) because it might help you get a much higher salary afterwards which will increase your net worth beyond the level you could have had without the education. 2) because without this education, you might have never been able to do your dream job.
And this is an important aspect. Originally, we said that good debt is only debt which increases your net worth. I would personally also consider debt to be good when it helps you achieve a life goal (such as getting into your dream profession) even if it decreases your net worth.
Do not get me wrong. If you are taking up student loans of CHF 160’000 to major in 18thcentury Egyptian pottery, then I still think it is bad debt. Simply because the amount of debt is staggering as compared to the potential income in such a field.
If you are planning to start your own company and you do not have enough cash to get you going, then debt can give you that extra push.
Some companies have no problem getting started from a financial point of view, but they then lack the necessary resource to scale their business. Again, debt might give a company that extra leverage.
Many new companies fail. 30% of business do not survive the first two years. That figure goes up to 50% if you look at the first five years.
Loaning debt to businesses, especially young businesses, is considered risky and therefore interest rates are higher than for mortgages. But for business owners, debt in this category is considered good, because it helps them grow their business and therefore their assets as well if all goes well.
Generally, car loans are considered bad debt. Simply because the moment you drive off the car lot of a car dealer, your vehicle already loses 10% of its value. After a year, it is only worth 80% of its original value.
Therefore, taking on debt for your car is the equivalent of investing in a money losing asset. A house may appreciate or depreciate. A car will only depreciate with usage.
The only reason why a car loan might be considered good debt, is because you need it to get to work. If you would not be able to make a salary without the car, for example because there is no public transport to the location of your workplace, then taking out a loan for your car generates value.
Lifestyle Items / Credit Card Debt
Generally, using your credit card is not a bad thing. Paying for your dinner, movie tickets or your holidays can be fine.
But this is only the case if you make sure to pay your credit card debt on-time and in full every month. If you do not, then the interest you pay on your debt is astronomically high. In Switzerland, credit card companies arelimited to a maximum annual interest rate of 12%.
The rule here is very simple: Do not pay for lifestyle items with your credit card, unless you have enough money to pay back the debt on-time and in full EVERY single month. Otherwise, make sure to pay in cash or avoid the expense altogether.
Payday loans / Cash In Advance
Some people go for payday loans when they are in dire straits for money and cannot wait until their next pay-check. This is what a payday loan is.
Avoid these at all costs.
The interest rates are unbelievably high, beyond what interest rate credit card companies charge you. Luckily in Switzerland these are not very common.
Things to Consider When Looking at Debt
As we have seen above, not all debt is made equal. Some is good, some is bad.
Nevertheless, even when getting a mortgage on a home, there are a couple of things to consider when looking to take on debt.
1) Consider the interest rate of the debt you are taking on. Is it super high? Then avoid it.
One of the questions you can ask yourself in order to figure out whether the interest rate is good or not is the following question:
If I invested this money in the market in low-risk assets (such as index funds), would I generate more money than the interest rate?
Therefore if your answer is yes, then you tick the first check-box. If your answer is no, then re-consider taking on the debt or leave your hands off of it.
2) Make sure you are not taking on too much debt. Even if you take on only good debt as per the examples above, it might still be too much.
It is important to calculate your debt to income ratio. In principle, you would list all your recurring monthly debt expenses, such as mortgage and credit card payments, against your gross income.
This will give you an indication of how well you can cover your debt expenses with your income. In the US, if you have a debt to income ratio of 43% or higher, then you would have a hard time finding a mortgage. Anything below 35% is considered acceptable.
3) Analyse the impact of changes in interest rate if it is variable. If one of your debts has a variable interest rate (for example your mortgage), make sure that you are financially able to cover a large increase. Especially if the loan is for a long maturity (say 30 years), then you need to be sure that a strong interest rate increase will not have bad consequences for you.
The Emotional Aspect of Debt
No good introduction to debt article would only consider the financial aspects of debt (just as with any financial topic, there is an emotional part as well). Anyone with debt will ask themselves: Should you always pay off your debt?
Based on our discussion above, the general answer should be:
For bad debt, always pay it off as soon as possible. For good debt, take your time in paying it off.
From a purely mathematical point of view this makes sense. Bad debt decreases your net worth, good debt increases it.
However, there is an emotional aspect to debt which we are not allowed to just throw to the side. No-one likes to owe someone else money.
If you are the type that feels oppressed by having taken on debt and it gives you headaches to think of it, then maybe it is a good idea to pay off so-called good debt as well. Why? Because you will sleep better at night and worry less.
In short, it would increase your quality of life and no-one should judge you for it.
Debt has many negative connotations and is not a light subject to discuss. Not all debt is good or bad. There are many different things to consider when looking at debt. I hope that the above introduction to debt gave you a better insight.
Please remember that even good debt can be bad for you if you take on too much. On the other hand, if used correctly it can accelerate your net worth, your business or your path to getting that dream job.
- List all your debts and their characteristics (maturity, interest rate, debt type)
- Calculate your debt to income ratio
- Categorize your debts from good to bad. Develop a strategy to pay down your bad debt.
What do you consider good and bad debt? Do you have any specific strategies in paying down debt? What surprised you in this introduction to debt article?
Let me know in the comments or send me an e-mail at email@example.com. Any questions, concerns, feedback and constructive criticism is highly appreciated.