I have heard a lot about “good debt” and “bad debt” – but what’s the difference?
The conventional wisdom is “Good debt is a housing mortgage or a student loan, bad debt is everything else – especially credit cards” – but let’s delve in a bit further.
Debt has been around as long as civilization, and often getting into debt meant having to sell your family members, sit in debtor’s prisons, or become a slave. Sometimes debt meant honor and honor meant paying your debts.
Many religions had an ethos that anyone who charged interest was evil by definition. While attitudes have become a bit more relaxed, those who charge excess interest or take advantage of the poor are often called usurers.
Even today, usury is still around, and still a huge problem. Things like “pay day loans” somehow exist, and can have unsuspecting people paying wild rates of interest. They skirt around the law by phrasing these charges as other things such as service fees.
Likewise, charging bounced check fees to someone who has no money in their bank account to begin with, or re-arranging debits to occur before credits just to be able to charge overdraft fees is really taking advantage of the people who can least afford it – but there is one reason why this is all allowed.
People are presumed to be adults when they reach a certain age, and adults are presumed to be able to enter into contracts. Therefore, you can agree to borrow money at 20% if you want to in many countries – and it’s your fault for agreeing to do such a stupid thing. So, it’s the borrower’s fault.
Likewise, for the creditor taking money from those who can’t afford it is simply business. After all, why should they suffer because someone else can’t manage their money? The fact that they can’t pay makes lending more risky, so charging ever higher interest rates can be seen as only fair.
In most parts of the world (certainly in Japan, at least), we are well past the period of debt peons, debtor’s prisons, and debt slaves – but people can still easily get themselves into situations they can’t escape. Spending money is easy, making it is difficult, and nothing ever goes as planned forever.
Say you buy that PS5, Gucci bag, or Rolex on your credit card, and then you lose your job. Well, now you need to prioritize your food and rent, and may even have to put your groceries on a credit card. You can pay your minimum payments for a while, but the balance decreases only very slowly. You had better find a job quickly if you don’t want to destroy your credit score.
Of course in this case, losing your job might not have been your fault, but not having savings was. Maybe you didn’t lose your job, but your house burned down. Here again, maybe it wasn’t your fault that the house burned down, but it was your fault that you didn’t insure it.
It’s always the borrower’s fault.
Well, I have to say – it kind-of is. People have become addicted to using credit for things they never should need to borrow for.
Is it the lender’s fault too? Sure, in a way. On the one hand, they are simply lending money that people want to borrow – on the other hand, they are doing it knowing a significant percentage of people won’t be able to pay them back. That’s factored into their business plan.
Debt has been one of the largest causes of misery in human history, so it’s worth exploring the topic a little further.
First let me define debt. Debt is owing more money than you have in liquid assets. I don’t consider owing $500 on your credit card to be debt if you have $10,000 in your bank account, because not only to you have net assets, but they are liquid enough so that you could (and should) pay down that $500 tomorrow.
I don’t consider debt that is due in less than one month, or one billing cycle to be debt for our purposes. If you charge your electric bill to your credit cards every month, and pay that every month it’s technically debt, but it will be discharged very soon and you won’t pay interest on it.
Likewise, I’m not talking about that $25 you owe your friend for the bar tab or karaoke bill last week. Presumably you have the cash to pay that, and will pay it in the next week or so.
What I am talking about are installment loans, shopping loans, cashing loans, personal loans, mortgages, credit cards, student loans, and other types of term loans and revolving credit.
I think there are two cases when it’s okay to borrow in this way:
- When you need something to work (and make money), goods for a business (that will make money with high certainty), or something that will save your money with high certainty.
- When you truly need something for basic personal purposes and you simply don’t have the money to pay any other way – but this should be a giant red flag.
Let’s cover some cases do you can see what I am talking about:
Loans for Making/Saving Money
- You have no savings, and live in the countryside. You are just starting out, and have been hired as a new graduate at a large prestigious company. You received an offer letter and accepted it – Just one problem, you start in 3 weeks, and have no car to get to work. There is no public transportation available and it’s too far to ride bike. Honestly, you should have saved up before, and you should look for alternatives – but if you truly have no other choice, then you might need to borrow money for the car to get to work and start making money. I would look to family first, and the banks second. I would buy the cheapest car I possibly could, so long as it’s likely to be reliable. I would also shop around for the cheapest interest rate I could find. Then I would save up cash for possible repairs in case on an unexpected breakdown, and pay off the loan as quickly as possible.
- You’re renting and you’ve found a great deal on a house. The bank has approved you for a very competitive fixed rate mortgage, and the cost of the mortgage payments is much less than your rent was – so that even when you factor in maintenance and management fees, insurance, property tax, etc., you will be paying less each month in total for the house than you were for rent. You are a proper employee at a stable company and have been working there for more than 5 years. Again, I wouldn’t buy the maximum house you could afford, but the cheapest one you can stand. I would get a 30 year loan, but then pay more than I need to each month, so that it can be paid off early and I would pay less in total interest. I would do this, of course, only after making sure I have an emergency fund.
- You run a successful business importing widgets from Germany and selling them online. You have been buying in batches of 100 widgets, and selling them at a $10 profit. The supplier gives you an offer – if you buy 500 widgets, they will give you a volume discount so that you only need to pay 75% of the price. You know you can sell the 500 widgets in less than 60 days based on recent trends. You don’t have the money to buy 500 widgets, but you get a loan from the bank at 3% APR so you can buy the widgets in bulk and increase your profit. The increased profit is easily much larger than the amount of interest you will have to pay.
- You are in high-school, and know from talking to your guidance counselor that you can go to a public trade school for $60k, and expect to earn around $27k per year to start when you graduate, or you can spend $125k go to a private 4 year college and expect to earn $45k per year (including bonus) to start. Your parents say they can only pay about $70k. In other words, if you spend the extra $65k to go to the 4 year college, you can earn an extra $18k per year. The interest rate on your student loans would be 4% in the worst case. This means that you will recover the difference in 4 years of working. Clearly, if the job market is good (and projected to still be good in 4 years) then it makes financial sense.
These are the kinds of scenarios where it makes sense to borrow. In every case, though, it would make sense to err on the conservative side:
- Buy the cheapest car you can that would be reliable. Find a used car with a warranty from a reputable dealer.
- Buy a house in a city where the population is growing, and one that is at least a few years old so that the “new house” premium is gone, but not so old that the maintenance costs will be sky high in a few years. Buy something that you can pay with 25% of your income or less. (You can buy a larger house later and rent out the old one).
- Importing 500 widgets to gain the cheaper price makes sense, but buying 10,000 does not. The widget prices might fall, or they might become unpopular before you can sell all of them.
- You don’t need to go to the most expensive college. You should research your options carefully to see which colleges actually increase your chances of getting a job where you want, and which have a food cost to performance ratio.
The key in all of these situations is to start small, and borrow the least you possibly can – but many people make two major mistakes:
a. They borrow for things they simply don’t need.
b. They “bet the farm”, borrowing enough to get themselves into deep financial trouble for many years to come if things don’t go well.
- If you borrow for an expensive car and you get into an accident, repair or replacement will be similarly expensive – all while you are still paying the original loan.
- If you buy more house than you can afford, then you will be in trouble all that much more quickly if you lose your job, interest rates go up, etc.
- If you borrow more than you should to buy merchandise, a large number of problems can occur. They could get lost at sea, the supplier could go bankrupt before sending them to you, the market value might go down, etc.
- If you pay more than makes sense for college, then you will be in that much more trouble if the job market isn’t doing well when you graduate.
In all of these cases, keeping your borrowing at modest levels decreases your risk and also decreases the amount you will be paying your creditors.
Think about it this way, if you buy a $400k home instead of a $200k home, you don’t just pay twice as much – you pay a lot more than that because interest compounds. Do you want to make your bank rich? You can buy the $200k house, pay it off, and then buy the $400k house while rent the original house out.
In fact with current market conditions in Japan, the rent from the $200k house would probably be able to pay at least half of the mortgage for the $400k house.
Likewise, with the merchandise resale business, you could borrow enough to buy 500 widgets, and using that profit, you could afford to borrow less to buy the next 500 widgets, and so-on, until you could afford to buy 500 widgets without using credit at all. Then you could ask for a further discount if you buy 1000 widgets. If the supplier accepts, then you could again borrow enough to buy 500 widgets, and put in your own money for the remaining 500 widgets – so that you can increase your profits even more without taking on as much risk.
With college, you could go to a school you can realistically afford, and if that works out well, you can always decide to go to graduate school later. This would be a safer option compared to going to the most expensive school and not being able to sleep at night when the job market goes south before graduation.
Put simply: Debt can make sense when you are borrowing someone else’s money to leverage in a way that is very likely to let you make (or save) money, and when you can afford to eat the loss if things go wrong. That last part is important. Don’t take the loan if you might end up underwater for the next 10 years if things don’t work out. Don’t take large leaps unless you are ready.
Imagine you buy the used car for $5k, and the company that hired you suddenly gets bought and renigs on their promise. You have to work at 7-11 for the next 2 years while you look for another job. Well, you can probably pay off a $5k car. If you had chosen a $40k car, the situation would be much different.
If you have to move because a family member gets sick after the housing market drops 5%, well, 5% of $200k is much less than 5% of $400k.
If the widget shipment never arrives and the company goes out of business after taking your money, you’ll be glad you didn’t buy 1000, because you can still pay the bank back and get back on track.
If you end up flipping burgers after graduating college because you had to drop out due to a medical condition, you’ll be glad you didn’t borrow to go to the Ivy League school of your dreams.
I’m not saying “don’t have dreams”, I’m simply saying “Take small steps”. Make sure you can recover if everything goes wrong. If you work hard then things will usually go right, and you can take the next step up the ladder – but sometimes things will go wrong.
The best situation to be in during those times is to have a financial cushion, but if that’s not feasible, at least don’t put the rest of your life at financial risk.
It’s true that you can’t be thrown into debtor’s prison anymore, but bankruptcy is something you should try to avoid if at all possible.
Basic Personal Needs
This section is a bit messier.
Ideally, you should never need to borrow for basic personal needs.
If you can’t pay your rent or mortgage, afford to buy food, etc., then you are in real trouble.
Still, if this situation does happen, and you know it’s only temporary, then sometimes borrowing to stay alive can be okay.
For example, you lost your job, and you already found one, but you are going to be without pay for 2 months. You have some cash in the bank. You could use your cash to buy food, or you could buy it on your credit card and pay for it next month. You are concerned about spending all your cash on food in case some emergency should come up, so you put your groceries on the card. Fine, I say.
The same thing could apply if you were on medical leave, or had some other unexpected expense blow your budget this month.
If, on the other hand, you have hit upon hard times and you don’t have a recovery plan handy, then I wouldn’t do it. You should be applying for unemployment insurance, disability insurance, welfare, or asking your family for help first.
If this is constantly happening to you, then it either means you can’t hold down a job, you have neglected to save, or you are monumentally unlucky. If you’ve neglected to save, it means you spend all your income, and probably run up your debt too. See the next section.
Other Expenses
It amazes me to see how many people use credit to buy things they just don’t need.
You want to buy a new phone? Sure, if you have the money. You almost certainly don’t need an iPhone 17 Pro, though. If your iPhone 12 no longer lasts very long between charges, you can always get the battery replaced. If you have an emergency fund, no other “bad credit”,your current phone is paid off, and you have the money for a new phone, then by all means. Congratulations! But if not, then why are you want to make your situation worse?
Do you really need the latest MacBook, the latest Sony Headphones, a PS5, yet another hand bag, pair of shoes, or yet more clothes? The answer is almost always “no”, and yet people convince themselves that they do all the time. Companies have marketing departments with the sole purpose of their existence being to convince you that you need more stuff – that your live would be so much better if you had that Rolex watch or Moncler Coat. Would it, though? A Casio tells time just a s well, and a Uniqlo coat is just as warm. Marketers try to convince you to buy this stuff because it will impress everyone around you, but the trust is monody cares.
I’m not saying you should buy everything at the dollar store – sometimes the cheapest stuff is not a very good value. The most expensive stuff rarely is either, though. More to the point, if you can’t afford to buy it in cash, then you can’t afford to buy it at all. Spending next year’s money today is a dangerous game that can make you feel dread instead of joy, rob your of your ability to invest, and cause you to fatten the wallets of bankers and companies when they should be fattening yours.
My point is this, what you really want is to get into a situation where you can invest money so that you make money from companies and bankers – but you can never do that if you owe interest bearing loans. Add to that the risk you will be taking on, and it makes no sense.
If you have at least a few months of salary sitting around in the form of an emergency fund, then you can weather any mild storm that might come. Taking on credit to buy things that you don’t need and that won’t make or save you money is like having a reverse emergency fund. It can turn any little bit of rain into a disaster from which it could be very difficult to recover. Finally, it also makes everything more expensive in the long run even if you pay everything off.
Think about it this way, if you invest in the stock market, you can expect to earn 7% in the long run, but let’s be conservative and say 4%. Taxes will be taken from this, so let’s say 3%. Now, if you buy your Gucci bag for for $4,000 on your credit card at 12%. Not only will you be paying something like an extra $240 for the Gucci bag due to interest, but taxes don’t decrease this amount. For every dollar you spend, you are already decreasing the amount you could save or invest, but when you have to pay interest on loan, it means that you basically can’t invest. If you invested $4000 in the stock market at the same time you bought the bag, then you could expect to earn something like $120 in the stock market after taxes, on average – but that’s only an average and anyway paying $240 for sure while receiving only an average $120 is simply foolish. You would be better to spend that $4000 you were going to invest on simply paying down the credit card you used to buy the bag. Sure, you could invest $8000 at the same time you spent the $4000 on your card to effectively neutralize the interest – but even then you are taking a risk. Basically, it never makes sense to buy anything on credit you don’t have to since it neutralizes a much larger amount of your investment.
Since it almost never makes financial sense to take on consumer debt while investing, and you should be investing – it almost never makes sense to take on any consumer debt. It’s that simple.
Personal Experience
I’m not afraid to say that I learned this the hard way. Like many, I had to take student loans, and I was offered credit cards when I was young.
I had the luck to get a good job with a good salary. I also always paid my bills, so I have excellent credit. This means banks kept raising my limits and offering to loan me more and more money.
It’s easy to spend more than you make, and it’s easy to run on auto-pilot and tell yourself little lies like “Just this one time”, or “I deserve it”, and before you know it, you’ve racked up an impressive amount.
Lenders make this seem innocent because they only charge you relatively small minimum payments, but this means you will be paying for more than 10 years in some cases, and half of what you pay ends up going to interest.
I realized that even in a world where investing didn’t exist, I was still paying almost twice the cost for some things just to stretch out payments. that $500 of headphones? Yeah, I ended up paying $1000 because I was only making minimum payments. The same with everything else.
In my case, I came to this realization when I started wanting to invest beyond just my retirement account. I realized that it didn’t make any sense at all to be paying the banks 6%-12% with clockwork certainty or more while I was making an unsteady 7 or 8% which was more like 5-6% after taxes were deducted.
Any dollar you can invest instead of spending will double, and then double again, and again… turning into many times the amount you put in. This is something to keep in mind, but spending isn’t a crime. Money is here to use.
If you spend to the point where you are needing to put things on credit – well then you are actually anti-investing. For every dollar you borrow, you are cancelling out multiple dollars of investment.
Once I thought about that, I started paying off my debt as quickly as I could, and became debt free in short order.