Debt: Never Good. Just Bad, Worse or Toxic!
Have you ever been to a seminar and heard the phrase ‘good debt’? Perhaps debt that allows you to negatively gear? Or debt that allows you to buy an investment property where the return is greater than the cost of servicing, thereby allowing you to make money out of thin air? It’s certainly a persuading argument as it tickles our greed glands.
Make no mistakes – while debt might be temporarily necessary (or perhaps useful in the sense of a double-edged sword), it is only ever ‘good’ for the lender who records it on their balance sheet as an asset. It is a recorded as a liability for the borrower, and liabilities are never good, just bad, worse, or toxic.
What Is Debt?
Debt is an advance on your future earnings.
In other words, when you borrow, you are reaching into the future and grabbing hold of future salaries, dragging them back and spending them today.
The more debt you have, the more committed you are to have to work – not just to meeting living expenses, but to pay back the ‘earning’s advance’. You become caught in a debt-trap once you’ve borrowed so much that you need your job more than your job needs you. That’s a very risky and dangerous way to live!
Here’s an interesting calculation (note: no information is stored, other than the number of times the calculation is performed):
Your goal is straightforward: Aim for $0 debt. That way you won’t owe anything to anybody and you’ll enjoy a sense of freedom only a precious few experience.
Bad, Worse & Toxic Debt
As I’ve mentioned, debt is a liability, so by definition, it can’t ever be good. Instead, debt can either be:
- Bad: meaning the interest is tax deductible
- Worse: meaning the interest is not tax-deductible
- Toxic: any debt past its due date for repayment
Bad debt is most commonly used to buy investments and hence might be temporarily necessary (but never good!), provided it is used in a controlled manner. Think of a school science experiment where you are using a very strong, dangerous acid: you want to respect it and be properly protected because it can cause severe damage if misused!
Thinking of investment debt as bad shifts your thinking to using it temporarily, sparingly, and only ever on your terms.
Worse debt is used to pay for a lifestyle in excess of earnings. A great example of worse debt were ads the CBA ran some years ago that featured the catchphrase “Where did you get the money for that? Equity mate!” Here’s one of the ads:
The marketing premise is that if you don’t have cash you need to buy stuff you think you want, don’t worry, just borrow against your home equity. You’ll be happier if you live your life in perpetual debt. Huh? Say what? Being convinced that debt is good (i.e. Equity mate!) is investing double-speak; clever marketing by lenders to trap you into a lifetime of interest repayments
Branding debt as worse will hopefully help you to use it sparingly, or even better, avoid it all together.
Toxic debt is debt that you have lost control of. Left unattended, it can kill you financially (which is why it is called ‘toxic’).
Take a moment and split up your total debt into its sub-categories of:
When Should You Use Debt?
You should only ever use debt when you can satisfy these three rules:
When you understand it
Most people understand the basics of debt: you borrow, you pay (interest), you repay (principal). Yet quite often there are some tricks that can trip you up. For instance, most interest-free credit cards require that you pay off the whole balance by the specified date. Fail to do that and interest is backdated and payable for that period on the whole amount borrowed, not just the amount that is still outstanding. Beware anything that uses “frill marketing”, such as low or no interest, extra loyalty points etc.
When you can afford it
You should only ever use debt when you can afford it. Never, ever, ever use debt to pay debt (i.e. meet interest or principal payments), and avoid as much as possible using it for lifestyle assets (which should be purchased for cash).
When you can escape it
The term “debt-trap” exists for a reason. Debt’s embrace seems warm at first, but ultimately becomes suffocating if you can’t escape its clutches. If you have a plan for getting into debt, make sure you have a plan for getting out of debt too.