There’s a scene in “The Wizard of Oz” where Glinda asks Dorothy: “Are you a good witch or a bad witch?” And Dorothy responds, “I’m not a witch at all.”
When it comes to debt, you may well ask “is this good debt or bad debt” as a way to understand (or rationalize) your current financial condition.
Good Debt—the kind where you get to take a tax deduction—is your home mortgage or a business loan to buy equipment or finance operations. But here’s a news flash: a tax deduction is never a reason to take on more debt than you need or can handle comfortably.
Another rationale for carrying a really big mortgage is the “future value of a dollar” argument. Basically, the dollar you spend thirty years from now is worth very little relative to the cost of a dollar today. And yes, that’s true. Think about the cost of a pack of gum thirty years ago vs. the cost today. The gum isn’t inherently more expensive, it’s just the value of a dollar has decreased. Make sense?
But what if all that “good debt” restricts your ability to achieve other goals in your life? Is it still a good idea?
Bad Debt—think Revolving Credit, aka credit cards—carries with it no tax deduction and typically high interest rates. You know the kind where you can make a “minimum payment” of $150 on a $15,000 balance and be at peace with the credit card companies. Unless you can pay off the balance each month, it is typically a screaming bad deal. Just because your card has a credit limit of $25,000 doesn’t mean you should use it. It might be a really good place to go in case of emergency, but for vacations, entertainment or other discretionary spending, carrying a balance on your credit card is a sure path to misery.
In reality, debt is neither good nor bad. It is a liability with an extra kicker attached that lessens your net worth and diminishes your free cash flow. That extra kicker of course is the interest charged—and regardless of the amount, it is the cost of doing business (unavoidable). Those with high debt are most likely living in a more perilous position than those with low or no debt. Unless you have a very high net worth (and if you did, why would you be carrying debt?), the loss of a job, a big unexpected expense, death or disability coupled with debt could be financially catastrophic.
Credit card debt can be a tool, a temporary bridge, to satisfy a specific situation. Think medical emergency, damage to property or something unexpected that just can’t wait. However, a tool can just as easily become a weapon when misused. After all, what’s easier than whipping out the plastic and focusing on the purchase rather than the bill that will show up in the next TWENTY FIVE days.
Carol is 28, an independent sales rep and a loving and caring aunt to her four nieces and nephews. When it came time for holiday shopping, Carol bought lavishly expensive presents for them, nearly maxing out her credit card in the process. The holidays were spent with great celebration and happiness. Except Carol didn’t expect the car wreck on the way home from a party, nor did she account for the broken leg and the deductible on both her medical and car insurance. Nor did she consider that her income source would dry up if she were unable to go out and see her customers.
The result was financial ruin. She managed to borrow money from relatives to stay afloat until she was back on her feet, but was left with tens of thousands in debt and nothing to fall back on. All those gifts for her family left her without a financial cushion and—after the accident—in a perilous position.
Debt isn’t good or bad, but it can lead to constraints and restrict your ability to react to unexpected situations. The higher the amount of debt you carry, the greater the risk to handle life’s emergencies (or opportunities). Debt encumbers you from saving, investing, expanding, exploring and ultimately living your values.
Just avoid the debt trap—it is certainly no Yellow Brick Road.