Determining Whether Debt Is Good Or Bad - Part 1 of 3
Many people see debt as a four letter word and yet others consider it part of life. Debt is a funny thing in that while it has derailed so many people’s lives there are others that have used it to generate tremendous success. The key is in understanding the difference between good and bad debt.
Debt that is obtained to create long term net worth can be good debt. Leveraging a bank’s assets to purchase an appreciating marketable investment can enhances your return.
For example: Imagine you have two options to purchase a business that you expect to provide $10,000 of profit in the first year. Option 1 you pay $100,000 cash or option 2 you pay $10,000 cash and obtain a $90,000 loan at 5%.
In scenario one, your first year expected return on investment (ROI) is 10% because you expect to make $10,000 on $100,000 that you invested. In scenario two, your ROI is 100% because you expect to make $10,000 on the $10,000 you invested. If you have somewhere else to invest the 90% that will exceed the 5% cost of the loan then you have leveraged the bank’s assets for you long term net worth.
While it may be good debt it can still get you in trouble. When identifying whether you can take on debt or not you have to pay significant attention to the cash flow needed to service the debt. It doesn’t matter what the bank is willing to lend you if you don’t have enough cash coming in to make the monthly payments. I am a strong believer that you never ask a bank how much you can have or use a ratio (like debt to income) to decide what you will borrow. The bank and the ratio don’t take in to account your other expenses that have to be paid.
The second and just as important part of cash flow is to identify your potential cash flow fluctuation. What happens if you have a child, you go on maternity leave and you have additional expenses to care for another family member? What happens if you lose your job? What happens if the investment doesn’t produce as much as you expected it to? Knowing what your risks are before you take on debt is key to making an informed decision that you can live with.
In Part 2, I will discuss bad debt.