Debt Isn't Bad (or Good), Painful Truth Is You Don't Know How to Use It Right

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Debt.

All of us know people who got in over their heads to the point that they don’t see a way out. They just keep paying far too much of their income just to “service” that debt, i.e., paying the minimum, which guarantees they’ll pay the most possible to their creditors.

In fact, there are so many people in that group that I wouldn’t be shocked if this includes you.

So, is debt bad?

Good?

Some of both?

Depends on who you ask…

“Debt Is Dumb” – Ramsey Solutions

We all experience things in life. Some of those experiences get seared so deeply into us that they alter our basic beliefs and how we operate in this world.

For Dave Ramsey, it was going bankrupt in 1988.

According to Ramsey Solutions, “By the time [Ramsey] was 26, he had a net worth of over a million dollars, but it all came crashing down when the bank called in his loans. He was left totally broke and completely broken.”

Going from millionaire (over $2 million in today’s money), making a quarter million dollars a year (about $577,000 in today’s money) to losing everything certainly qualifies as a searing experience. The result? Ramsey started crusading against all debt.

In his opinion, any positive result you can get from debt is completely undone by the risk.

There’s an expression in Hebrew that roughly translates to, “A cat once scalded by boiling water is afraid of warm water.”

Two Senior Men On Camping Holiday With Fishing Rod — Image Credit: Depositphotos.

“Stop Calling it ‘Good Debt’” – Sam Dixon Brown

Fellow Making of a Millionaire (MoaM) writer Sam Dixon Brown takes issue with people calling any debt “good,” but does allow that some debt, such as a mortgage or student debt, can be “productive.”

Brown points out how many people get trapped in a debt spiral and decries people calling some forms of debt “good” because that normalizes debt.

“Four Common Uses of Debt that Keep You Poor, and One that Can Make You Rich” – Jason Clendenen

Another fellow MoaM writer, Jason Clenenden, takes a more nuanced approach.

He calls out four common uses of debt as bad for your financial health.

Credit cards
Auto loans
Home mortgages (for primary residences)
Student loans

However, he points out, “The prudent use of debt to invest in stable, cash-producing assets is a great way to turbocharge your returns and even get rich.” For example, using mortgages to buy residential rental properties, which is how he is building his wealth.

He writes, “That is why I disagree with people who say all debt is bad. MOST debt IS bad, but there is a way to use it prudently to boost your finances, which is why I do believe in ‘good debt.’”

Debt Is a Powerful Tool. Use Cautiously and Only When Appropriate

Is debt good or bad?

Neither.

It’s an extremely powerful tool that can help you get things done that you can’t do otherwise. However, just like other powerful tools, using it involves a level of risk.

For example, there’s no question that a chainsaw is a powerful tool.

Used correctly, it can quickly turn a towering tree into logs, that you can then turn into lumber. Used incorrectly, it can cut off limbs or even kill. However, even if you know how to use it correctly, anytime you do there’s some risk you’ll make a mistake and hurt yourself or someone else. That’s why you don’t use it to cut a piece of lumber that you can cut more safely with a circular table saw or even a handsaw.

Christine Luken, Financial Dignity^® Coach, Founder of 7 Pillars LLC also likes tool analogies for debt, “I like to say, ‘Debt is like a slingshot or a shovel. It all depends on how you use it!’ I prefer to keep my own personal debt to a minimum and only take on ‘Debt with a Good Purpose.’ If I buy an asset that will appreciate over time (real estate) or allows me to increase my income (business ownership), that’s debt with a good purpose. You’re using debt to slingshot your finances forward. But if I use debt to buy clothes or a vacation I can’t afford, that’s going to hurt me financially in the long run. That’s using debt like a shovel, digging yourself into a deep hole.”

MoaM founder and editor, Ben Le Fort once wrote a piece, “Ranking the 7 Types of Debt from Worst to Best.” Here’s his worst-to-best ranking:

Payday loans
Credit cards
Personal loans
Auto loans
Student loans
Mortgages (for primary residence)
Mortgages (for rental properties)

So, are these “bad debts?”

As is the case with all things personal finance, the answer must start with, “That depends…”

Payday Loans

If you just started a job, and have no money nor any better way of getting it, is it better to starve or take a payday loan?

Yes, payday lenders are notorious for charging inordinately high interest rates, and their “customers” far too often get trapped, having to borrow again and again, continuing to pay those unconscionable interest rates. However, if you have no other choice, and make a clear plan for getting out of the trap, this sort of debt may be the lesser evil.

Credit Cards

How about credit cards?

I routinely charge thousands of dollars rather than pay cash. However, I don’t use them to pay for things I couldn’t pay in full upfront. I don’t use them for my credit history. And, I don’t charge any more than I would pay in cash.

I use them because the cash rewards are a nice source of income, because I never pay interest, and because I don’t increase my spending to get more rewards.

Personal Loans

As Le Fort notes, these carry lower interest rates than credit cards (let alone payday loans), so they can help you reduce your interest costs if you’re carrying balances on high-interest credit cards.

However, using these to buy stuff you can’t afford is a bad idea.

Auto Loans

Cars are well known to be depreciating assets. Taking out an auto loan at high interest to finance an expensive car isn’t smart.

However, taking out a loan at low interest rates (my last few auto loans charged 0% interest!) to avoid selling investments that earn higher returns is smart.

Student Loans

Getting a degree is often a great investment, increasing what Le Fort likes to call your “human capital.”

However, not all degrees are created equal.

Borrowing $200,000 to get a teaching degree that may get you a job earning $50k is unwise. Borrowing the same to become a doctor who earns hundreds of thousands a year is a good investment. You need to compare the amount you borrow to your post-graduation earning power.

Also, ask yourself if you can’t get a comparable education at lower cost. If you can get a similar degree at a less well-known school, your future earnings may be similar, but the lower cost means you’d have lower payments and more options.

Primary Residence Mortgages

This one is, in my opinion, a no-brainer in most cases where buying a home is right for you.

I’ve written about this elsewhere, so I’ll just summarize here.

The low interest rate made possible by the lien on your home, the fact that inflation eats away at the balance you owe over many years, and that in many cases you get a tax deduction are a powerful combo. In fact, by my calculation, I’ve effectively made 4 figures this past year from the mortgages I owe.

Even here, use debt in moderation.

Buy as much home as you need (or reasonably want). Your lender will look at how much he thinks you can pay knowing you’ll lose your home if you missed several payments, and will almost always tell you that you can afford to borrow more. Unless you want to be house-poor, acknowledge that and only buy as much house as you planned to.

Mortgages on Rental Properties

Did I mention that debt is like a powerful tool, and just as dangerous?

Buying rental properties leveraged by debt can help build wealth far more rapidly than almost any other investment available to you (just ask Clenenden!).

However, it’s also risky, so make sure you don’t:

Overpay for properties
Buy properties that aren’t likely to be easy to rent
Borrow overall more than you can carry for a while between renters
Take out variable interest loans and/or loans with balloon payments

Just ask Ramsey what can happen if you take on too much risk with too few safety nets.

Should You Always Pay Off Debt as Quickly as Possible?

If you listen to Dave Ramsey, the answer is almost invariably “Yes!” though his “baby steps” start with a $1000 emergency fund.

However, that’s not always the savviest way to deal with debt.

Alan Rhode, CFP^®, CPWA^®, CEPA^®, RLP^®, Founder & CEO, Private Wealth Advisor, Modern Wealth enumerates six scenarios where he’d advise clients to slow down debt payment, “As a private wealth advisor, here are several examples of scenarios where I might advise a client to take on debt or not pay off debt faster than the minimum required: (1) You can borrow at a low interest rate and invest the funds in something with a higher rate of return (e.g., mortgage interest might be lower than expected stock-market return, though this comes with inherent risk as investment returns aren’t guaranteed); (2) If a client has irregular income, keeping more cash on hand rather than aggressively paying down low-interest debt offers access to liquid funds during lean times; (3) If paying off debt faster would drain your emergency fund, it’s advisable to slow down the repayment and maintain a safety net; (4) The interest on certain debt (e.g., mortgages and student loans) may be tax deductible, effectively reducing the cost of borrowing, so it may be better to pay these off slower while using your cash for other purposes; (5) Debt with low interest rates (e.g., mortgages or some student loans) might not be worth paying off aggressively; and (6) If you aren’t maximizing your retirement savings, particularly when an employer matches contributions (free money!), it often makes more sense to increase those savings before paying extra towards low or moderate-interest debt.”

Dawn Mabery Chestnut, CFP^®, MSPFP, MPAS™, CFEI, Mabery Consulting, LLC agrees with some of these, saying, “Someone on a fixed income should be cautious about quickly paying off debt, as I advised a retired couple who wanted to know if they should pay off their mortgage using tax-deferred retirement account funds. Also, someone experiencing difficult financial times (e.g., layoff) should pay the minimum debt due until their finances become more secure.”

The Bottom Line – The Right Way to Use Debt

Think of debt not as borrowing from the lender, but rather as taking (more money) from your future self so you can spend it now. You get to use money today without taking it out of your current resources. However, your future self will need to pay it back, with interest.

Think of debt not as borrowing from the lender, but rather as taking (more money) from your future self.

When deciding to borrow or not, put yourself in your future self’s place and ask if s/he’d be happy you put her/him on the hook for it, given what you plan to buy.

For example, take a payday loan to pay for food and your future self will probably be happy you did so if it prevented you from dying of starvation. S/he’d be very unhappy if you took it to buy a big-screen TV.

Take out a modest student loan to give your future self opportunities s/he wouldn’t otherwise have, and s/he’ll be eternally grateful. Borrow more than needed just to go to a big-name school, and your future self will likely think you made a mistake. Borrow hundreds of thousands to get a useless degree, and s/he’d be quite upset.

Doug ‘Buddy’ Amis, CFP®, President and CEO, Cardinal Retirement Planning, Inc. sums it up, “When I work with clients on debt, we use some of the same evaluation tools and techniques we’d use to evaluate trades. What are the risks, costs, and exit strategy? At the end of the day, taking on debt is a trade of future time and future money, so protecting yourself against unnecessary or excessive amounts of risk, minimizing costs, and knowing ways out is essential to mitigating the biggest problems with debt.”

The best use of debt is to only borrow money when it helps you build wealth, with acceptable risk, and with enough safety nets in place to protect your future self from the consequences should those risks materialize. Even then, minimize how much you borrow as far as reasonably possible.

Disclaimer: This article is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

About the Author

Opher Ganel

My career has had many unpredictable twists and turns. An MSc in theoretical physics, a PhD in experimental high-energy physics, a postdoc in particle detector R&D, a research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started several other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. I draw on these diverse experiences to write about personal and small-business finance to help people achieve their personal and business finance goals.

Follow me on Medium (opher-ganel.medium.com).

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This article originally appeared on Wealthtender. To make Wealthtender free for our readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a natural conflict of interest when we favor their promotion over others. Wealthtender is not a client of these financial services providers.