If you’re struggling with debt, then you may have been told to pay off your “bad debts” first. Experts disagree, however, on what makes a bad or good debt.
Is your worst debt the one with the highest interest rate? Or the one you can pay off fastest? If some debts are “good,” does that mean it’s OK (or even expected) for us to be in debt for most our lives? The banks seem to think so.
Conventionally toted “good debts” like student loans and mortgages take up to three decades to pay off.
Americans today are taking even longer to get out of debt, though, because of refinancing options like home equity lines of credit. These may shrink monthly payments, but they also extend the life of debt by several years, resulting in the average American household owing tens of thousands of dollars past the age of 75.
Again, this raises questions about so called “good debts.” Long past the age of retirement, some American households struggle with the same old debts and even take loans against their pensions or life insurance policies to make ends meet!
If we don’t want to join the statistics and be in debt the rest of our lives, we need a way to measure what makes debt worthwhile. Fortunately, such an evaluation already exists, it’s just rarely talked about in the personal finance realm. This equation is called expected return and it is frequently used by investors, entrepreneurs, and business owners before they invest in a new project.
What does this investing term have to do with eliminating personal debt?
Traditionally, financial gurus call debt “good” if the debt eventually increases your net worth. For example, buying a home may come with a mortgage, but it also comes with an extremely valuable piece of personal property. Similarly, a college degree costs thousands in student loans, but also increases your potential lifetime earnings. These are common “good debt” examples because they make you money over time despite the upfront costs. In other words, they are investments.
Risk vs. Reward
Investments are tricky, however. If you don’t carefully research a project beforehand, you could lose a lot of money on a risky investment.
No one knows this better than a business owner, but because of measurements like expected return businesses can intentionally go into debt and still end up millions of dollars richer. Studying business debt is also helpful because it is relatively simple compared to personal debt. Businesses don’t have sick relatives, emotional needs, or any other factors that make personal spending, well, personal.
Understanding the correlation between good debt and investment, with a straightforward business examples to learn from, can help us prioritize our personal spending, pay down debt faster, and even avoid further debt in the future.
So, how do businesses handle debt?
Business can take on debt in a variety of ways, but there is only reason they want to. First and foremost, a business wants to make money. Sometimes it doesn’t have enough cash on hand to buy new equipment, expand into a new market, develop new products, etc. That business can therefore take on “good debts” to quickly get the cash it needs to expand and increase its overall value.
“Good debt” is measured by its rate of return, a comparison of how much the value of a purchase increased versus its initial cost. If a purchase does not have a high rate of return, then that purchase did not generate much income. Low returns can put an entire business at risk of failing.
In other words:
Good debt = high returns (lots of money generated compared to initial cost). Bad debt = low returns (little to no money generated compared to initial cost).
Rate of Return
The key to rate of return is the comparison to the initial cost of a purchase.
Say a business takes out a loan to purchase new equipment. The new equipment produces $1000 a month and lasts five years. If that equipment costs $10,000, then it just created a huge rate of return. ($1000 a month for five years is $60,000. That is much more than the initial $10,000 loan.)
If that equipment instead cost $100,000 then that business loses money on that purchase despite working the equipment five years. In fact, the business loses much more than the difference in their original purchase price because it is still responsible for interest payments to the bank and the cost of maintaining the equipment while it’s running.
That’s why businesses invest so much time and energy into researching markets, calculating the cost of production, and estimating their rate or return. They understand that debt should be assumed only when the purchase increases the value of the business. Individuals may not have the same fancy equations as businesses, but they can still be this thoughtful before taking on new debt.
Let’s go back to the example of home ownership. After the most recent recession, the value of real estate is steadily continuing to rise. A home lasts decades, making it an excellent investment and well worth the potential debt.
Student loans, on the other hand, do not have the same rate of return. While it’s true a bachelor’s degree can increase your lifetime earning potential, the average American still only earns 1.8 million dollars throughout their lifetime.
As advanced degrees also become more common, better employment is no longer guaranteed, thus further decreasing the expected return of these debts. This does not make student debt “bad” necessarily, but limiting the amount of debt through part-time work, scholarships, and choosing less expensive programs will help you get a better rate of return, and thus more wealth, overall.
Real Life Application
This same measurement can be applied to any future purchase. Thinking of buying a luxury car to impress your boss and get promoted? Although that car loan does have the potential to increase your earnings, the same result could be achieved by taking your boss out to drinks once a month and remembering their birthday. The later would save your tens of thousands of dollars and therefore have an excellent rate of return.
The same can be said of using credit cards to buy designer clothing or redoing the kitchen to impress your in-laws. Before you buy, ask what action would make you the most wealth by calculating your expected return. When you learn to evaluate your spending in this way, you’ll find it’s easier to prioritize not only paying off current debt but also avoiding new debt altogether. You’ll be using the strategies of the most successful businesses to one day retire rich.
Do you think there are good types of debt? Share your answer with us in the comments below!