Good Debt, Bad Debt, and All Other Kinds of Debt

Lots of commentary on my post titled Good Debt versus Bad Debt and most of it surprisingly agreed with my opinion that almost all debt is bad. I say surprisingly because most people (who are usually in deep debt themselves) will argue that their credit card debt is ok for this reason or that reason. But not this time -- most people were in the "debt is bad" camp. The commentary started with this thought from a reader:

Instead of "good debt, bad debt", how about "bad debt, worse debt"? Or "tolerable debt, bad debt"?

Ha! Yes, that gets to the heart of what I was saying.

I like this thought as well:

No debt is really good, since even under the best circumstances the return is always less than zero, but without a doubt some debt is worse than others. It is sort of like trying to figure out if it is better to be punched in the face or the gut.

For many people who are on a treadmill of financing day to day purchases it might be useful for them to make an incremental improvement from credit cards to a home equity loan. Maybe the same person can, with discipline, make the move from paying interest to collecting it through investing.

I absolutely love the quote: "It is sort of like trying to figure out if it is better to be punched in the face or the gut." ;-)

Then we get the naysayer:

What if you could borrow money @ 2% fixed for ten years. And you took those proceeds and bought a 10-year treasury earning 5%.

Is it bad debt to earn a risk free 3% spread? This is completely hypothetical and not currently possible.

But would you consider this bad debt?

Another commenter saw the validity of this point:

That's a good point Frank. And it's not completely hypothetical. Many of us get 12-month 0% or 2% credit card offers. If we maxed out a credit card with such an offer, and not put any other debt on that credit card, and used the cash to buy a 12-month CD at 5% (current rates), would that be bad debt? Of course, being very disciplined in paying the minimum payment every month. This is something that many of us could do today. But a fair argument would be that "this isn't the point", that the point is "to get and stay out of debt".

I, however, wasn't as open-minded. Here's my comment on the suggestion a couple comments above:

Here's the part of the idea that doesn't work for me:

It's "completely hypothetical."

This is the same thought I had when I wrote:

"Yes, there are those who will talk about how they can earn more than the cost of the debt by investing, but from what I've seen, this is much more theory that reality. In fact, of all the people I've ever heard talk about how it's smart to have debt because they are only paying X% while they can earn X+%, I've never seen one actually do it. Besides, remember that when you make a debt payment, you've just made a GUARANTEED investment (by reducing the cost of your debt). When you invest, you may get that expected return and you may not."

So:

1. I've never seen anyone actually do what you're suggesting with any sort of discipline.

2. Maintaining/servicing debt is a hassle and time-consuming.

3. Is it worth it for 2-3%? Not likely. You can probably gain much more in other areas of your finances by spending the time there.

Another commenter agreed with me:

That's a good point, but it's not completely risk free. There is still the risk of running into personal problems -- losing a job, for example. Unless you have a solid emergency fund in addition to what's invested in the treasury, you'll start running into trouble quickly.

Bad debt and worse debt is a good way to look at it. I wouldn't recommend leveraging debt to invest in higher-return investments unless someone is extremely disciplined to do so and is on solid financial footing already. It's not a way to "get ahead."

All that said, we ended with a comment from a reader who is executing the interest strategy proposed above -- and doing fairly well with it:

I currently have about $11,000 in an HSBC savings account that I have borrowed at 0% from credit cards. It does take some discipline and organization. It'd not be a good idea for me had I not had some credit problems in the past and been forced to go cash-only for a few years. I'm no longer in the habit of spending money I don't have, or at least will have this month, and I don't intend to get back into it. I do have other savings to cover expenses for six months if I should lose my job for some reason, plus I can draw on my Roth IRA if that's not enough.

My FICO score has taken a hit from this, admittedly, since I'm running at or near my limit on several cards. But I don't need to apply for more new credit right now -- and if I did, I can "buy" it by forfeiting some future interest and paying off the cards now.

I'll make about $500 in interest this year from doing this, which doesn't sound like much, I suppose, but I think of it as a tenth (after taxes) of next year's Roth IRA contribution.

Comments

[Blaine Moore (Run to Win)]

I agree with the bad debt/worse debt, except in a few instances.

For example, the costs of starting your own business might be prohibitive. Getting a small business loan might get you some start up capital and hopefully to the point of being profitable so that you can pay the debt off. There is a lot of risk in starting your own business, but in many cases the rewards of being independant can far outweigh the risks.

Most people probably could not save enough money on their current income to get the start up capital in a time frame that would allow them to realistically start their business. If you are ready to start a business now, and could get it operational in a few months to a year with a business loan, that would under many circumstances be much better than having to wait for 8 or 9 years to save that same amount for start up costs.

On a side note, the nice thing about a lot of online businesses is that they can be started and made profitable for pocket change and not require a business loan to get started.