MAKING CENTS: Good debt and bad debt – so what’s the difference?

I was asked recently what I thought good debt was, and what I thought bad debt was?

And I’ll tell you in a moment, why I was asked this particular question, but before I do, my answer was pretty simple i.e. good debt is when you borrow money that’s going to be used towards something that will either increase in value over time or it will be used to help you earn more money over time.

To put it simply, good debt in my book is debt you’ll be glad you took on for what it helped you create.

An example of good debt is buying a property because not only does it help you to become a homeowner, but you hope, and you hope because it’s not a guarantee, that the property will increase in value over time and if you ever did sell it, you’d make more of a profit than what the mortgage cost you.

Another type of good debt in my opinion is when it’s used to further your education which will make you more attractive to employers and as a consequence your earning capacity will increase from where it is now.

More of this to come shortly because it’s the reason I’m writing this article.

Bad debt on the other hand is considered bad for a number of reasons, some being (a) whatever you used the borrowed money to purchase or finance, that thing goes down in value over time or (b) you can’t afford to pay the repayments in full each month.

And buying a car could be considered bad debt because over time it’s practically guaranteed to go down in value.

For example, if you bought say a new Toyota Corolla costing €33,435 and your annual mileage was 12,000 and you held on to it for five years, it would be worth about €18,864.

So, it has depreciated in value by 43.6% which in real terms means it’s going down in value by €243 per month.

And that’s according to a website called moneycalculator.com, who’ve stated that they’re 78% confident that the number they’ve produced in this instance is correct. And by the way there are many different makes and models of cars that have a higher depreciation rate than the one I’ve just mentioned, but I have only room to give you one example.

Anyway, if you financed the full purchase cost of this car, your monthly repayments over five years would be €655 and the total interest paid back would be €5,876.

So you’re making monthly loan repayments of €655 on something that is going down in value by €243 each month, and I think you’ll agree it’s not a great use of your money, because you’ll end up spending €39,311 over five years’ on something that will end up being worth €18,864.

And maybe I’m oversimplifying things, because people need to borrow money to buy cars, of course they do. They buy them out of necessity and don’t look at what their future value will be. It gets them from A to B and that’s enough for them. But perhaps they can dial down the amount they borrow and redirect some of what could have been loan repayments, to savings accounts instead.

And then of course there’s credit card debt and that’s really an awful debt to have, particularly if you make the minimum repayments each month.

If you’re carrying debt of, say €5,000 and the interest rate charged is 20%, and you’re making a minimum repayment of 3% every month, it will take you 18 years four months before it’s paid back, and you’ll end up paying c. €861 in interest payments.

Enough said, it’s an awful debt, no doubt.

Now let me tell you about instances where I think taking on debt is very good and no better way than telling you about a gentleman who reached out to me recently, because he is thinking of doing an MBA in a couple of years’ time and he wanted to know how he was going to fund the cost.

And the total cost was very big. He told me that a one year course at the London Business School was going to cost him about €130,000, between course fees and accommodation.

Very long story short, through a combination of a gift from his parents and savings he already had, there was still going to be a shortfall of €75,000 and he wanted to know how this could be funded.

And given that he was two years away from starting the MBA, he had that time to save and the maximum he could save was about €1,040 per month, which meant he’d have to take on a personal loan of €50,000, which at a rate of 6.80% would cost him about €980 per month over a five year period.

And that’s what he had thought it would be, but he wanted someone else to verify it for him.

This MBA was coming at a huge cost to him, and I guess before you consider taking on any debt like this, you must run the numbers to see if it’s worth your time and money.

And according to one calculator I came across online, which was using real time salary outcomes from MBA graduates and salary data captured from corporate recruiters, based on this young man’s years of experience and the industry he was in (consulting) he can expect to receive a salary increase of about 40% in his first job after earning his MBA.

And if this was true it would mean his income after taxes was going to be €1,280 more each month than it was now.

The benefits of investing in that MBA for him as I saw it were (a) he would have more choice in the location and type of property he could purchase in the future if he wanted to become an homeowner, because he could borrow more money because of his higher salary (b) he would have €1,280 more each month which meant he could save twice as much each month than he used to and (c) his lifetime earnings would be about €800,000 more with the MBA than without.

Three very compelling reasons to take on a personal loan of €50,000 and if he was wavering about the overall cost of his MBA coming in at €130,000, and he was, when we ran the numbers, he knew the investment of his time and his money in the long run was going to be worth it.

I’ve come across another person who was thinking of taking a sabbatical from work and returning to college to complete a master’s degree at a total cost of €34,000. And she found out from a recruitment agency that the particular sector she works in, she could expect an uplift in earnings of about 12% by having the masters.

And if the differential stayed the same, she knew she’d earn c. €144,000 more over her working life.

And she was happy therefore that her investment of €34,000, which was a mixture of savings and borrowings, was going to produce an excellent return.

If anyone is considering completing a masters or going on to do an MBA or doing anything that furthers their career solely for the purpose of increasing their earning potential, you need to know if there’s going to be a payoff particularly if you have to take on debt to fund whatever studies or course you’re going to complete.

Once you understand what that differential is, you’ll be able to see if the investment is going to be worth it in the long run, and again this is just looking at the impact only from a financial perspective, nothing else.

In summary, if you are taking on debt for whatever reason i.e. education, a house, a car, a holiday, I’d say ask yourself how this debt will benefit you, not just today but in the long term. Is the debt going to provide you with a lasting benefit, will it pay you back more than what you put in, could you be doing something better with the money rather than making loan repayments each month, do you have any other options other than borrowing the money, do the loan repayments fit into your monthly budget and are they something you can easily manage etc.

And I’ll leave you with this thought, before you ever complete a term loan application form, or sign on the loan agreement dotted line, try to remember this: Ask not what you can do for your debt but what the debt can do for you.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at [email protected] or www.harmonics.ie