When I was in business school, I was told that there are two types of debt.
Good Debt and Bad Debt.
Just like there is good food and bad food, I thought debt must be the same. Right?
There is no such thing as a “Good Debt.”
And if we aren’t careful, even a “Good Debt” can get us into a whole lot of trouble very quickly.
That is why in this post, I want to talk to you about “Good” Debt.
What it is and why we should be very careful when we are dealing with them.
Home Mortgage Loan
The most popular “good debt” is our good friend – the home mortgage loan.
If you own a home, there is a good chance you purchased it using a home mortgage.
I mean with the crazy low interest rate right now, it’s a bargain, right?
However, what we don’t realize beyond the numbers and the interest rates, is how it affects our buying behavior.
The easy availability of home mortgage loans, tempt too many buyers into buying homes they don’t need or that are way more expensive than they need.
And the whole mortgage industry encourages it.
When have you ever worked with a real estate agent or a mortgage lender that told you to spend less on a home?
The agent makes more money, the more expensive the house you buy.
The mortgage lender makes more money, the more loans you take on.
Almost every mortgage lender that I worked with always started with:
“Hey Mr. Kim, great news, you’ve been approved for a Billion dollar mortgage – now go out and find a home that allows you to borrow that much!”
Now, I’m not bagging on mortgage lenders, because I’ve worked with some great ones who allowed me to take advantage of some amazing interest rates.
But we need to understand what everyone’s primary incentives are.
As the Sandwich Generation, our goals are financial security and ultimately financial independence.
This means we want to hold as little debt as possible.
We should seek the least house to meet our needs, rather than the most house we can afford as told by our mortgage lender.
When we purchase more house, greater the ongoing cost.
And this is not just in higher mortgage payments. But also in higher interest, property taxes, insurance, maintenance and utilities.
And let’s not forget, when you have a big house, you need to furnish it as well.
Let me tell you an interesting story about this.
In the 16th Century, there was a famous French philosopher named Denis Diderot who had co-founded the Encyclopedie, one of the most comprehensive encyclopedias of the time.
Ironically despite his fame, he was quite poor. And to make matters worse, his daughter was about to be married, but he could not even afford the dowry.
When Catherine the Great, the Empress of Russia, heard of his financial troubles, she offered to buy his library from him for today’s equivalent of approximately $50,000 US Dollars.
Suddenly, Diderot went from being in poverty to having money to spare.
To celebrate his good fortune, Diderot purchased a new scarlet robe.
And that’s when everything went downhill.
Diderot’s robe was very beautiful. In fact it was so beautiful that he immediately noticed how out of place it seemed when around his regular possessions.
In his words, there was
“no more coordination, no more unity, no more beauty” between his robe and the rest of the items in his house.
And this is when he went on a spending spree.
He decorated his home with beautiful new furniture – a new kitchen table, a new mirror to place adobe the mantle, and a new leather chair. The list went on.
Today, these reactive purchases are now known as the Diderot Effect.
We obtain a new possession and that leads to a spiral of consumption of other new things.
We have a brand new home. And now that old IKEA table doesn’t look too good at the massive dining area. Time to buy a new one.
The old minivan doesn’t look that great in this upscale neighborhood. Time to check out the Porsche dealership.
Take advantage of the low interest rates and the secure 15-year mortgage.
But, be careful not to be tempted into buying the biggest house you can “afford” just because your mortgage lenders say you can or your real estate agent tells you, you should.
The second on our list of “good debt” is my personal friend – the Student Loan.
I have quite an extensive experience with this guy here – you can learn more about my wife and I’s journey to paying down our $105,000 student loan here.
When I was in college at the University of California, Irvine from 1999 to 2003, the annual in-state tuition was around $4,000.
With my part-time job as a valet and my stipend from the US Army ROTC program, it was enough to cover the $4,000 needed for the school year.
Now fast forward to today, 20 years later. My nephew is in his 1st year of college and the annual tuition at the same school – UC Irvine has increased to almost $14,000.
A simple Compound Annual Growth calculator tells you that the annual growth rate is close to 6.5%.
Average inflation rate in the same period from 2003 to 2021 is 2.29% according to an inflation calculator.
So essentially, college tuition has increased by 3x more than the inflation in the same time period.
And this is just looking at a local public state university. When you compare private universities, the problem here is many times worse.
Make no mistake – easily accessible student loans have played a huge role in this increase.
Just think how easy it is for a young 18 year old to get him or herself a $20,000 student loan.
All you need is a college acceptance letter and a pen.
I know, because I was that kid – sadly, I was 28 years old at the time and not any wiser than an 18 year old.
And the real scary part of student loans is that you can never walk away from them.
Unlike a home mortgage, where the bank will just take away your house and you can walk away free – student loans survive bankruptcy.
It can garnish your wages and even your social security.
From the bank’s perspective, this is a godsend product.
They can continue to collect from you until the day you die.
Think hard about taking student loans – whether for yourself or for your children.
Good education doesn’t have to cost you an arm and a leg.
Home Equity Loan
Third on our list is Home Equity Loan or Home Equity Line of Credit, aka HELOC.
These are essentially the close cousin to a home mortgage.
If you own a home and have some equity within it, I’m sure you are bombarded by banks to take some money out.
With these loans, you are essentially using the equity of the home, the value of the home minus the mortgage as collateral.
Many people use home equity loans to make home improvements, such as to replace a leaking roof, fix the broken driveway, etc.
However, most often, people have a tendency to use these home equity loans as another bank account to pull money from.
Thus the popularity of the Home Equity Line of Credit. Instead of taking a lump sum of money, HELOC allows individuals to pull money as needed – just like an ATM.
But this is another danger of a HELOC – people forget that this is borrowed money. Not your checking account.
I’ve seen people use HELOC to upgrade their perfectly fine kitchen, remodel their well functioning bathroom and even buy things not related to their home – a new boat, a new car, etc.
My recommendation is this. Don’t use Home Equity Loan or the HELOC.
If you need to upgrade the roof because it is leaking, save for it.
When you have access to easily accessible money like the home equity loan, you may find it hard to resist the urge to get that new kitchen marble counter you always eyed.
Make the decision simple and just not allow yourself that temptation.
Number 4 on our list is business loans.
This was another lesson I learned in business school – it’s normal for businesses to borrow money and in many cases it is necessary.
Used wisely, this recommendation makes sense.
If an asset can generate steady revenue, it makes sense to finance the purchase of that asset with low interest debt.
However, I believe many people interpret this statement in a very wrong way.
Many hear the statement that:
“You need a business loan in order to start a successful business.”
This is far from the truth.
My good friend, Alan Donegan has worked for many years to flip this myth.
Check out the “Rebel Business School” where you can see how he and his team is helping people to start in a business the right way – with no debt.
The main lesson here is that debt is always a dangerous tool and the history of business is filled with thousands of companies ruined because of the debt they took on.
And you don’t have to look far to find them – ever heard of Blockbusters? Or Lehman brothers?
There you go guys. 4 supposedly “good” debt that you should be wary of.