If you’ve ever wondered when borrowing money is okay and when it is not, read on to learn more about good debt versus bad debt. You will learn about household debt statistics, how debt works, the pros and cons of debt financing, what scenarios make debt good or bad, as well as how to paydown your debt.
When is it okay to borrow money?
Through Family Finance Mom, I hope to empower all household financial decision makers with basic financial skills necessary for making the best decisions you can for you and your family’s future. Before diving into specific questions and topics, however, the best place to start is with an understanding of the basic building blocks of finance: interest rates and capital structure.
Last week, I addressed LIVE on Instagram interest rates and why interest rates change. This week I’m talking about capital structure, which for family finance purposes is whether or not to use debt as a source of financing in your life. You can watch the entirety of the of the LIVE replay on my dedicated family finances Facebook page, Family Finance Mom, and find a summary of the discussion, and all the referenced resources below.
Debt, The Magnifier
Before you borrow money, it is important to understand the impact debt has on potential outcomes. If you have ever wondered how hedge funds make outsized returns, the answer is debt… and personal debt has the same effect.
Borrowing money magnifies your current purchasing power – allowing you to make purchases larger than you can currently afford. And it also magnifies any future returns (or losses). Let’s look at a basic mortgage, the largest source of household debt, as an example.
When you buy a home, you can fund the purchase with all cash, in which case you own 100% of the equity of the home, or by financing a portion of the purchase price with a mortgage. Most conventional mortgages only allow you to borrow up to 80% of the value of the home, requiring you to put up the remaining 20% of the value with your down payment, representing your equity value in your home. This magnifies your purchasing power – you are able to buy a home with only 20% of the purchase price paid in cash. Now, let’s look at what happens if your home rises in value.
If your home increases in value by 20%, if you purchased it entirely with cash, you will earn a 20% return on your original cash investment. However, if you only put up a 20% down payment and financed the rest of the home with debt, that same 20% increase in the value of your home, equates to a 100% return on your cash investment, or equity, magnifying your return. The same is true in reverse.
If your home were to decline in price, losing 20% of its value, your losses are also magnified when borrowing money. An all cash purchase would experience a 20% loss or return on equity, while a home purchased with only a 20% down payment would lose the entirety of the down payment, for a 100% loss or return on equity.
The way a mortgage magnifies the return (or loss) on your down payment is exactly the way many hedge funds and private equity funds generate outsized returns as well. They make investments using a small amount of equity, funding the rest with debt, and amplify the equity returns.
Types of Debt
Not all household debt is attributed to mortgages. The most recent consumer household debt report released by the Federal Reserve indicated the highest levels of consumer household debt ever, surpassing $13 trillion at the end of 2017. With 126 million US households, this amounts to an average of $104,000 of debt per household.
Mortgages make up the largest share of it ($8.9 trillion), but the fastest growing categories in recent years are student loans ($1.4 trillion) and auto loans ($1.2 trillion). While other debt categories have actually declined since the housing bubble collapse of the last decades, student loans have grown at nearly 10% annually. If you recall our discussion about paying for college, this is a big reason why I believe college and student loans are the next potential financial bubble.
While student and auto loans have grown, all other consumer household debt categories – including mortgages, home equity loans, credit cards and other forms of personal debt have declined.
So what makes good debt versus bad debt?
There are some financial programs out there that will tell you all debt is bad, and you must eliminate all debt entirely. I would argue, however, that there is good debt and bad debt, just as much as there are good and bad investments.
As an example, my parents and I could never have afforded my degree from Notre Dame, which led to my eventual highly compensated career, if it were not for my ability to take out student loans. So what makes that good debt versus bad debt?
Examples of Good Debt
Good debt is defined by a situation where you are borrowing money to ultimately generate a return higher than the cost of the debt, that also eventually allows you to pay off your debt. Student loans, when properly utilized for a degree that leads to a career generating income ample enough to cover the cost of your degree and interest on your loans, is a good investment and good use of debt.
Related Post: Evaluating College as an Investment Decision
Business loans, to finance business expansions, are another potential example of healthy borrowing. When you are taking on debt to purchase a large asset that will likely appreciate in value and your earnings more than support the interest on the debt, like a mortgage to buy a home, is also a good use of debt.
Student loans, mortgages, business investments are all forms of debt that provide a future return or future earnings potential. However, all still have to be carefully vetted and evaluated before you borrow the money. Always be careful to not borrow more than you can afford to maintain, and keep in mind that the persistent low-interest rate environment we have experienced for the last decade or more, will very likely be changing going forward, making the cost of borrowing higher.
Related Post: What Every Borrower Should Know About Interest Rates
Examples of Bad Debt
What are examples of bad debt? Any time you are borrowing money to finance a purchase that immediately declines in value as soon as you buy it – that is an example of bad debt. This includes using credit cards to fund clothes, food, travel, personal goods and services, furniture. If you buy it and can’t resell it for the same or a higher price, buying it with debt is just making it cost more.
Auto loans are also bad debt. As soon as you drive a car off the lot, it declines in value. Depending on your down payment, it could even be worth less than what you owe on it. If you lose your job in 3 months and need to sell the car, you could end up with less than you need just to repay the loan… and no car.
Interest and debt principal payments have to be made no matter what else happens in your life. If you lose your job, get demoted, or are injured or out of work for a period of time. If you can sell it to cover the debt balance – like your house, you are in a better position financially, than if you can’t – like with a car, furniture, or clothes.
The Crowding Out Effect of Debt
The Crowding Out Effect is a macroeconomic concept. It basically says that when the government borrows money to finance its spending, the increase in taxes required to sustain the debt, as well as the higher interest rates from their borrowing, reduces public spending and investment.Spending today with borrowed money is borrowing from your future ability to spend. So when is it okay to borrow?
Crowding out happens on a personal level too. When you carry substantial debt balances, even if you aren’t adding anything to those balances, every month, a sizeable portion of your wages are already spoken for by the interest and principal payments you must make. This crowds out other purchases and investments you might want to make. Spending today with borrowed money is borrowing from your future ability to spend.
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The latest census results are already exhibiting this impact with millennials given their high student loan balances. Nearly 1/3 of young people (24 million ages 18-34) live with their parents – which is more than live with a spouse. Millennials are getting married later and starting families later, and homeownership rates are lower too. The only positive for this demographic is they are achieving higher levels of education, especially among women… but at what cost?
How to Paydown Your Debt
My Family Finance followers typically have two key questions – how do I invest or how do I paydown debt? I have a guest post over on What’s Up Fagans? about exactly that. Learn which debt to pay off first, and the steps to take to figure out how to paydown your debt most cost effectively.
Related Post: How to Know Which Debt to Pay Off First?
Hopefully, you now have a clear understanding of how debt works, and what makes good debt versus bad debt. Understanding how debt financing works, along with how interest rates are determined are the two core concepts you need to understand to start to build your financial skills and successfully manage your family finances.