Bad and worse debt

I advocate that there are two kinds of debt: bad debt and worse debt.

Bad debt is something you get into temporarily. I call it ‘bad’ because the consequences of mismanaging it are, well, bad. You could face financial hardship, maybe even financial ruin.

Worse debt is money borrowed to buy stuff that’s worth less, or worthless, immediately after buying it.

Does that mean you should avoid debt completely?  Yes, if it’s worse debt, and maybe, if it’s bad debt.

If you befriend bad debt, ensure:

  • It will return a greater gain than its cost
  • It must be temporary for as long as it suits you
  • You must have a realistic plan for getting out of debt
  • The debt repayments are made before you pay yourself.

What about using debt to buy assets?

An asset is something that has a future value, perhaps because it can generate income, or can be sold.

Assets can either be lifestyle or financial in nature: a financial asset is a purchase for profit and a lifestyle asset is purchased for enjoyment.

Sometimes the line between the two can be a bit blurry, so a simple rule to remember is that a financial asset will never be used for lifestyle purposes.

The safest rule to follow is to never use debt to buy lifestyle assets. If you can’t pay cash, don’t buy it.

This is problematic because a home is a lifestyle asset and almost everyone borrows to purchase their home.

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The consequence is having to work many tomorrows to pay for it, becoming bound to your job and therefore having less time freedom. If that’s a price you’re willing to pay, then so be it.

If you’re looking to use debt to purchase an investment, then a test to undertake is to compare the asset’s income return (as opposed to its capital return) against the loan’s debt service cost.

Self-liquidating debt is the safest unsafe debt there is. To be self-liquidating, the debt must be used to purchase assets that generate enough realised income to cover the loan’s interest and principal repayments.

Non self-liquidating debt is where the loan service costs are higher than the investment’s realised income. The bigger the shortfall, the higher the investment’s risk.

For instance, if the income return of an asset was $1000 but the debt service cost was $1400, then you would need to fund the shortfall ($400) from other sources.