“Borrowing money is destructive to your finances.”
“Loans are great for building wealth.”
Which of these statements is true? You may be surprised to learn that depending on the circumstance, both are. Debt tends to confuse people, and many have a love-hate relationship with it. Most families have at least some debt and go to great lengths to establish and maintain good credit. However, no one likes the thought of being beholden to lenders and getting rid of a home mortgage is considered a milestone celebratory event. Debt is a powerful financial tool to be handled with care. Like a power saw or drill, it can help you reach your goals much more quickly and comfortably but when utilized frivolously, quite hazardous.
The Cohens With Bad Debt
To illustrate, consider Yanky and Devorah Cohen. Married for six years, they were making ends meet but barely. With two children and one more on the way, Yanky’s salary as a sales manager was looking smaller every day. He was hard working and hoped to earn a larger salary, but considering his current skills, this desire though was unrealistic. The Cohens had recently financed the purchase of a late model minivan for Devorah and also splurged on a beautiful vacation in Eretz Yisrael. While the vacation and new vehicle were a bit extravagant, it was nothing their friends and siblings didn’t indulge in and were doable thanks to the credit card and bank.
However monthly car payments and credit card minimum payments were starting to bite. While their income had always covered the standards like rent, utilities, and food, there was nothing extra to cover the new debt. This monthly debt obligation was quickly eating through their savings, intended for a future down payment for a permanent home. When their landlord raised the rent, they had to put more and more of their expenses on credit cards. Thus began a vicious cycle. Minimum monthly card payments grew along with the balance, creating a larger deficit which the Cohen’s needed to charge. The again raised the minimum amount required monthly and so on. The Cohens little extravagance had become a debt nightmare, and their wish to buy a home was now beyond reach.
Debt: The Double Edged Sword
Financial planners differentiate between “Good Debt” and Bad Debt.” Bad debt is used to pay for consumable things like vacations and cars. Consumer debt tends to have high-interest rates and unfavorable terms with no asset remaining to cover the growing obligation. These characteristics make consumer debt difficult to manage which leads to the debt spirals.
Good debt, on the other hand, finances an investment which adds to the borrowers’ earning ability and net worth. These investments include real estate, businesses or career education. These loans have lower interest rates than consumer borrowing, along with easier payment terms and tax breaks. Over the long run, responsible use of good debt, helps people improve their lives and create wealth well beyond what they’d achieve on an all cash basis. By way of example, consider an alternative Cohen debt story.
The Cohens with Good Debt
Yanky Cohen knew he had to make some changes. While his salary currently covered their budget, he needed to start earning more money to support his growing family. Their landlord raised the rent annually, and Yanky and Devorah hoped to afford a permanent home lo their own. With the blessing of his wife and advisors, Yanky joined a two-year nighttime CPA course. While they needed to use student loans to cover the $45,000 price tag, most graduates of the program tended to be placed quickly at salaries at least $20,000 above Yanky’s current salary! The $45,000 invested in the credential was then an excellent investment. The loan had a reasonable rate and required no payments until after he graduated and found a new jobno These terms would not place an additional burden on their budget.
BH, the two years passed quickly and as planned. Although the Cohens had to delay some purchases such as a new van and a long awaited vacation, the sacrifice was well worth it. Thanks to his newly acquired skills, Yanky was promoted to junior controller at his firm at an increase in salary of $2,000 monthly! Yanky and Devora agreed that after paying the $500 monthly student loan payment, a similar amount would be saved up to pay for some of the “extras” they had put off like the van and vacation. They had earned it and now could afford it! The balance of the increase ($1,000) would add to their nest egg for a house down payment. Although buying a home would require a large mortgage, they had the income to support it. They also had gained the confidence that to use debt responsibly to attain their financial goals.
“Good” Debt Can Go Wrong Too
Of course, even good debt can be misused. Much money is lost when people take out mortgages they can’t afford or finance education which does not lead to good careers. Good debt must be used in a healthy, balanced way. Billionaire investor, Warren Buffett, warns in a shareholder letter:
“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.
Too much of a good thing is bad too.
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