When Can Debt Be a Good Thing?

The word “debt” sounds scary, intimidating, and carries a negative connotation for many. We’ve made debt a cultural boogie man, something to be avoided at all costs. While everyone’s situation is unique, there are instances when, if used properly, certain kinds of debt can also a powerful tool for building your own success story.

The Business of Debt

Many companies carry debt on their balance sheet. There are a number of strategic reasons for doing so but the primary purpose is to finance parts of their business (acquisitions, inventory, etc.) to accelerate growth and ultimately, future profitability. There are two primary benefits to this. First, companies can deduct the interest on the debt from their corporate income taxes, which brings their cost of debt down. In addition, using debt is cheaper than financing using equity. If the company is run well and has positive future growth prospects, using debt could be extremely valuable.

“Well, I’m not a business, I’m a person.” We hear you. But some of the ways businesses think about debt can be applied towards your personal finance.

Does “good” debt exist?

Although many forms of debt aren’t traditionally thought of as “good”, there are circumstances in which taking on debt can be beneficial if it allows you to make a purchase that will pay off in the long-term. This pay-off can either increase your net worth or increase your income. It’s also important to remember that debt doesn’t have an inherent moral value, it’s simply a tool that you can figure out how to best use to serve you end financial goals. Now, what could beneficial debt look like for you?

🏠 Mortgage debt

Most of us don’t have enough money saved to buy a house outright.  This is where a mortgage loan comes into play. Sometimes the monthly cost of owning a home, including the mortgage, can be less expensive than renting a comparable property.  Residential properties have historically increased in value which could increase your net worth as you build equity. The IRS tax code also provides tax benefits for homeowners, including the possibility of deducting home mortgage interest and state and local real estate taxes.

🎓 Student loan debt

There are many horror stories about the dangers of student loans, and they should be thoroughly researched and planned before you commit to anything but a college degree can create opportunities. While it would be great to graduate college without any debt, this isn’t realistic or attainable for many. This is why student loan debt can be a debt worth taking on – it is debt that may ultimately pay for itself and help you further your chosen career path.

Things to consider before taking out student loan debt:

• the cost of the college or university you will be attending

• the income potential of the major that you study or degree path you choose

• other savings and financial assistance that may be available

Some careers may also be eligible for student loan forgiveness through public service loan forgiveness and other programs.  Depending on your income level, you may also be eligible to deduct your student loan interest.

💼 Starting a business

Another situation where debt could help you is borrowing money to purchase or start a business. If you’ve done your research and this business provides a worthwhile product or service and is managed well, the company should generate a profit and become a sound investment. It’s also a good option if you aren’t interested in investors or parting with any equity as part of your business strategy.

How to Quickly Determine if Debt Will Boost Your Financial Success

The main thing to focus when adding debt to your financial picture is whether that debt will enable you to earn more money or increase your net worth. If you are not using it to buy an appreciating asset, but rather to buy depreciating assets or anything disposable because you don’t have cash to pay for it, that’s when you might re-think your purchase.

If you borrow money to purchase something, think about these criteria:

1. The amount borrowed should be within your ability to repay without placing a strain on your budget. Calculate your Debt to Income Ratio (DTI) and try to keep it below 35%.

2. The item should be something that will increase in value or produce an income.

3. The value of the item should be equal to or worth more than the amount borrowed to purchase the item.

4. The length of the loan should also be shorter than that useful life of the item being purchased. (Don’t get a five year loan on a used car with so many miles or existing issues that it’s likely to break down in three years)

5. If you are using debt to purchase an asset (real estate, margin investing, etc.) you need to feel comfortable and confident that the returns you will generate from the investment will exceed your cost of borrowing (interest rate).

What’s The Verdict?

If you’ve done the research and found adding to your debt will overall help your financial situation, debt can be used as a tool to facilitate wealth building. The next time you are evaluating a new potential debt, keep the five criteria above in mind to help you make a mindful decision that doesn’t create more financial stress in the long run.