Not all debt is necessarily bad or disadvantageous to your goals. For many of us, and especially entrepreneurs, debt is merely a fact of life. What most of us don’t realize is that when used responsibly, strategic debt is a tool to improve one’s long-term financial situation.
However, to remain financially comfortable in the long run, you must first understand how to use debt to your advantage. This touches on how to do just that.
Some say that we’re living through a consumer debt crisis in the United States. In aggregate, U.S. consumer debt totals $14.3 trillion, and every American household with a credit card averages roughly $6,591 in revolving credit card debt.
Not all debt, however, is created equal. The cost of one’s debt is defined by the debt’s interest rate, often denoted as an annual percentage rate (APR). The interest rate is the percentage of the principal (i.e., the amount loaned) that the lender charges the borrower for the use of its money. Interest is calculated from the unpaid portion of the loan outstanding.
For the borrower, higher interest rates are costlier and signify a lack of confidence on the part of the creditor. In other words, banks and other lenders charge high interest rates on credit cards because they consider this type of debt to be riskier (i.e., there’s a lower chance of it being repaid).
Whether a debt is considered “good” or “bad” often comes down to the term of the loan and the APR charged on the principal. However, the APR also includes any ancillary fees, such as brokerage fees or closing costs for large capital purchases.
Let’s take the example of a mortgage for $250,000 over a 30-year amortization period at a fixed rate of 4.75% APR. Under these terms, the borrower would owe the following:
• Monthly payments: $1,297.
• Principal payments: $250,000.
• Interest payments: $216,972.
• Total cost: $466,972.
What Makes A Debt ‘Bad’?
In short, good debt is an investment. As an investment, it’s expected to grow in value or generate recurring income in the long term. For instance, attending college while taking out student loans is an example of good debt for many Americans who otherwise wouldn’t be able to pursue their careers. In the mortgage example used above, the purchase of their home is an example of good debt because it builds home equity and may generate a passive income.
Federal student loans and mortgages are usually considered good debt because they carry relatively low interest rates and the interest paid on them is tax-deductible. The same is true of auto loans on most budget-friendly vehicles, especially if the vehicle is essential to running your business.
By contrast, a debt is “bad” if it is used to purchase a depreciating asset, cannot generate income in the long term or cannot be reliably repaid. Often, bad debts carry high interest rates. For example, most credit cards have around a 20% interest rate and are therefore considered to be bad debt given that borrowing costs accrue so rapidly.
Examples Of ‘Bad’ Debt
The most common example of bad debt is a payday loan. In the case of payday loans, the borrower receives a cash advance, plus a fee, at a very high interest rate (often 300% or higher annually). If the full loan amount plus the processing fee is not repaid by the expiration date — usually the borrower’s next payday — then the loan “rolls over” and incurs yet another processing fee.
Payday loans are a common example of debt that can spiral out of control and cost your business its financial security. Entrepreneurs are commonly advised against using payday loans for their personal or business expenses, even to cover short-term cash flow issues.
Examples Of ‘Good’ Debt
On the other hand, there are many examples of good debts that contribute to one’s long-term financial security. A few examples of good debt that can contribute to one’s net worth or business success include:
• Home equity loans.
• Home equity lines of credit.
• Student loans.
• Some auto loans.
Essentially, good debts are any debts that can be sustainably repaid and contribute to one’s financial success. Business owners shouldn’t shy away from taking on good debt if the benefit of borrowing exceeds its cost.
Using Debt Wisely
Debt is a strategic tool that can be used to grow your business. On the other hand, it can be a business’s downfall, and even good debt can be overused and abused.
Knowing the differences between good and bad debt is, therefore, a key step in building a financially viable company — especially if you foresee the company taking on significant leverage. Before taking out a new loan or credit line, always ask yourself whether you see the loan turning a profit for, or contributing to the long-term growth of, your organization.