So what is “good debt”? It’s a general term for a debt used to finance something that expected to increase in value. Maybe you take out a mortgage to buy a home you expect to appreciate. Maybe you borrow student loans to help you increase lifetime earning potential. Or maybe you get a business loan to fund your start-up. All of these are common examples of good debt.
So if good debt is good, then more good debt is better, right? Well, not always. Yet it seems many people are operating this way. As financial planners, we regularly come across people who are feeling financially restricted because they have so much “good debt”. Some of them have even gotten to the point where they’re in trouble. So we’re going to talk about how you can avoid this dangerous place.
The dollars and cents part is simple. Understand the numbers, draw a line, and don’t cross it. But why do so many super smart finance-types still mess this up? Because the behavioral part is the real challenge. There are sneaky tendencies that work subconsciously behind the scenes that cause you to do things you know you shouldn’t do.
Let’s say you need a loan to buy out a business partner who no longer adds any economic value to your business. The minimum annual profit you expect to receive on the additional equity is 20%. The interest rate on the debt is 5%. It doesn’t take a math whiz to figure this out. Returning 20% on something that costs 5% is a really good deal as long as you can handle the risk.
But what about something like a home? How do you determine the expected risk and return of this type of investment? There are plenty of people who would argue over this one. Robert Shiller said in this NY Times article that the real return of US home prices from 1915 to 2015 was only 0.6% per year. That’s a pretty lousy investment. But you have to also consider the fact that you’re avoiding rent costs — but then also paying upkeep costs. The rent vs. buy analysis gets complicated quickly. But most experts agree that the value of buying a home versus renting a comparable home is generally higher if you plan to stay in the home at least 3-5 years.
What about student loans? Education is one of the best investments you can make. If you can get a student loan for $50,000 and increase earning potential by $20,000 every year for the next 20 years, that’s a really good deal in my book.
Pretty simple, right? If you finance an investment with a debt that has an interest rate lower than the return on the investment, it’s generally a good deal. If you plan to live in a home long term, buy. If you need to finance education with student loans, do it.
The Behavioral Aspect
So when does good debt turn bad? Take an example: John is renting a $200,000 home and is looking to buy soon. He talks to a lender and learns that he will qualify for a loan up to $500,000 with 100% financing. He believes that mortgages are good debt and buying is typically wise if you plan to live in the home long-term, which he does. In his mind, he has checked all the boxes and decides to take out the max $500,000 mortgage. The problem is that he is comparing apples to oranges. Buying a $500k home is much more expensive than buying a $200k home. In fact, the average upkeep costs on the $500k home is likely more than the rent costs on the $200k home. Therefore, he will never break-even on this particular deal.
The same thing happens with school loans. You want to go to engineering school and convince yourself that it’s wise to finance this investment. However when selecting schools, you fail to consider costs and end up selecting the most expensive school. It’s got all the fanciest dorms and full meal plans. And that all gets wrapped into the student loan.
The problem here is people are using bad numbers to justify their decisions. I’m going to buy this fancy house because it’s much better than renting. Or I’m going to this fancy school because I want to invest in my education. Don’t fool yourself. This is a lifestyle decision financed with debt. I’m not saying that nice houses and schools are necessarily a bad decision. What I’m saying is that you would be wise to call it what it is. If it’s truly about the numbers, make it about the numbers. But if it’s just about increasing lifestyle, don’t pull the wool over your eyes.
How can you avoid this? Use a realistic apples to apples comparison. Don’t always go with consumer norms and rules of thumb. Have a little healthy skepticism. Keep in mind the people you work with to help you make these decision may have major conflicts of interest that can sway their opinion. When you’re considering financing something, think like a business would. What is the highest possible ROI I can get with this money? Is it the budget school while living with my parents or the fancy school with the decked out options? If you want to splurge on the nicer option, call it what it is. Increasing your lifestyle is just fine as long as you can afford it.
We love helping our clients keep a level head with these kinds of decisions and would love to help you, too. If you’d like to chat sometime to see if we might be a good fit, click here to schedule a no cost consult.