Good debt versus bad debt

I was recently reading an article in the Wall Street Journal called Americans are taking cash out of their homes and it is costing them. Here is an excerpt:

Over the past two years, a big chunk of homeowners took on higher interest rates when they refinanced to tap their home equity.

These cash-out refinancings, as they are known, free up money homeowners can use to pay down credit-card debt, renovate or invest in a new property.

Interestingly, there is a boom in people taking equity out of their homes. Our memory must be short as families completely forget how that worked out after the last financial crisis.

I thought the author really missed the mark on this piece. Overall the families mentioned in the article were trading low-interest mortgage debt for higher interest mortgage debt which is almost never a good thing. The article discusses how great these cash out equity refinances are because people are able to pay off credit card debt. What the author really overlooked is the difference between good debt and bad debt.

Good Debt

Good debt is debt that is used for investment purposes. The investment being the keyword as it is much different than speculation which is more akin to gambling.

Investing would include buying assets such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, real estate, commodities, and a variety of other financial products.

Ideally, these types of investments would generate cashflow. Cashflow is important because it makes the debt you borrowed against easier to repay. If you have a dividend-paying stock, then you can use the dividend to repay the debt. If your investment works out eventually the debt is paid off and you still have the asset.

Student loan debt can be good assuming it can lead to a higher income that is sufficient to repay the loans and still yield a good return on investment.

Bad Debt

Bad debt is the exact opposite. You go into debt using Credit Cards, Home equity loans, Auto loans and use the proceeds to do something that is not an investment.

Examples of bad debt would be going into debt for an expensive wedding, vacations, buying electronics, buying more house than you really need, unnecessary home renovations (the return on investment when selling is typically 50%), buying an expensive car, overspending on Christmas, etc.

The key here is that these types of debt are not generating income-producing assets. They are not productive debt: the money is immediately squandered and no asset exists. Instead of making your debt easier to repay, they actually make your debt harder to repay.

Debt is a tool

Debt is not inherently bad. It should be thought of like a tool. A tool can be very dangerous or it can be very helpful.

For example, think about a chainsaw. Before the chainsaw was invented, typically large two-person saws were used. They took up a lot of space, required two people to operate them, were slow, required a lot of physical labor, and were much more dangerous.

A chainsaw is a fabulous tool that can be used to take down a tree. One person can probably do the work of 6 to 10 people using two-person saws. It can also cut the tree down into useful firewood and make it easier to move blocks of wood.

Unfortunately, if you are not careful with a chainsaw it can also be a very dangerous tool. It could cut your arm off if not used safely.

Debt is the same way. It can be a useful tool that can maximize your financial net-worth, create liquidity, and provide financial flexibility. On the other hand, it can also be used in our consumer materialistic society to dig yourself deep into debt towards the road to bankruptcy.

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