Good Debts and Bad Debts
Posted by Frugal on March 6th, 2007
Borrowing money is to use financial leverage. When is getting a loan a good choice? Borrowing money is only good when it actually helps you to make more money. Borrowing money is bad when it does not help you making more. This answer is simplistic, but should be mathematically evaluated on a case by case basis. Since the cost of debts is in the amount of growing interest money that you need to repay, you can determine whether such debts are good for you by calculating your potential return after borrowing such money and comparing the return to your interest cost.
Since your return may not be for certain in most cases, you should discount your potential return by the chance of success. For example, if you think you have 80% of chance to succeed in your undertaking venture, you should discount your potential return down by 20%. Such risk assessment is simply a good business practice. When the interest cost is lower than your discounted return, such debts are potentially good debts because it would help you to make more money.
The best example of a good debt is a car loan so that you can drive to work, earning a salary. In all cases, your salary will exceed the cost of transportation, or else you should not be even going to work. However the best example for a bad debt is also a car loan, but for luxurious car so that you can show off to your neighbors and colleagues. Getting into such debts only to prop up your own self-esteem really doesnât help your money. Categorically speaking, most credit card loans for consumption fall into the category of bad loans, while most mortgage loans fall into the category of good loans.
Knowing how to borrow money smartly is to understand using the power of financial leverage properly. Such understanding will improve your money-making potential. Remember to always use the leverage carefully because it is always a dual-edged sword. When debts are involved, caution must be always exercised.
Posted by “Frugal” at My 1st Million At 33.com
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March 6th, 2007 at 9:19 am
How would you ascertain whether debt accrued while getting an education is a good debt or bad debt?
March 6th, 2007 at 4:46 pm
I have accrued over $50,000 in student loans. I am trying to decide whether I should re mortgage my home to pay off the student loans. Interest rates are reasonable for mortgages right now, but my loan payment is only $400 ish per month.
March 8th, 2007 at 10:31 am
I’m not sure if I really agree re:car loans. The problem is that most people buy way too much car.
I had a 23-year-old employee who got pre-approved for a $35,000 car loan. He was getting paid about $40K at the time. I talked him into buying a used version of the same new car he was looking at and he ended up paying $10,500.
A $10,500/36 mo. loan from a credit union/bank (which is what he got) ends up being a pretty reasonable payment. He ended up paying about $235/mo with no money down for taxes/licensing. The car has performed well for him, and he has no regrets, and his payment is manageable…but before I talked to him, he was convinced that new was the only way to go. A $1000/mo car payment would have been totally unmanageable for him, yet the credit union he went through pre-approved that.
That’s why I say car loans are such a problem. Financial institutions, unfortunately, have way too loose lending standards at this point. I think in 5-6 years we’ll see this tighten to the other extreme, but right now, lenders are loaning out crazy amounts to young people with little credit.
I would amend your statement to say that a car loan of
March 8th, 2007 at 10:32 am
Your blog is cutting off less-than signs…
March 9th, 2007 at 3:43 am
Sanjay,
In respect to student loan, it is quite tricky in my opinion. The biggest unknown factor is how much you can really make when coming out of school. If you go to some highly paid and highly demanded sector such as being a medical doctor, you can easily assess whether it is worth it or not. I bet in most cases it is worth it assuming you get thru the program. In other cases, it can be tough to judge.
March 9th, 2007 at 3:45 am
Bart,
If you can deduct student loan interest, I don’t see a compelling point to mortgage unless the interest rate differential is big. Otherwise, I wouldn’t want to put more risk into home-owning unless you are very financially disciplined.
March 9th, 2007 at 3:52 am
SlashChick,
You have a good point. The math is critical to whether the debt is a good loan or not, especially in the case of car. I definitely would not be buying a new car with a loan of $35000 when my salary is in 40K range. However, “investing” in new durable car that is less than $20K may be worth considering. Many Japanese cars can be driven for 200K miles or 20 years. My oldest car is in its 12th year now. Still going abide some minor problems.
But nothing beats a good used car. They are deals to be had if you know how to discern good from the bad lemons.
You can send me the remaining fragments of your first comment via email or in the comment section. I should be able to patch it up, if you like me to do so.