Financial advisers will tell you that debt is evil. So just how evil is debt on a scale of 1 to 10 - with 1 being your average politician and 10 being Adolf Hitler? What would you say if I said to you that debt can be a good as a warm ray of sunshine through your window on a cold winter’s morning and as bad as Adolf and his satanic crew of stormtroopers?
So, what determines whether debt is good or bad. Here is a quick test to find out exactly where your debt sits on this very broad spectrum of goodness/badness. This test will work on points. There are a series of questions and each answer you select will accrue a fixed number of points, You will need to add up your points at the end and then the rating on your debt will be revealed. Question 1: Who lent you the money?
1) a bank (3 points)
2) a reputable online lender (5 points)
3) some guy I met at the end of a dark alley (1 point)
Question 2: The interest rate on the debt/loan (per annum) is:
1) below 10% (7 points)
2) between 10% and 20% (5 points) 3) between 20% and 50% (3 points) 4) more than 50% (1 point) Question 3: Did you spend or invest the money? 1) spent it (1 point)
2) invested it (5 points)
Question 4: On what did you spend the money? 1) a new car (3 points)
2) a new nose (1 point)
3) a new house (4 points)
4) a vacation or household appliance (2 points)
5) invested it (7 points)
Question 5: Is the debt collateralized (is it backed by some asset like a house or car)?
1) Yes (5 points)
2) No (1 point)
Question 6: If you invested the money, is the return on your investment higher than the interest rate on the debt? 1) Yes (7 points) 2) Not yet, but in a few months (5 points) 3) No (1 point)
Question 7: When does the debt mature?
1) Less than 12 months (5 points)
2) Between 2 and 3 years (3 points)
3) Between 3 and 5 years (2 points)
4) More than 5 years (1 point)
Question 8: Is the interest rate on the debt fixed or variable? 1) fixed (5 points)
2) Variable (3 points) 3) I don’t know (1 point) Question 9: When you applied for the loan/debt, did you have to lie on the application?
1) Yes (1 point)
2) No (5 points)
Question 10: Is this loan/debt a source of anguish/concern?
1) No (5 points)
2) Yes (1 point)
Below 20 Your debt is uglier than a junkyard dog. You need to pay it off as quickly as possible because it is going to grab you by the throat and suck the life out of you. Between 20 and 50 Your debt is neither good nor bad – it could go either way. It is taking more out of you than you are taking out of it. You need to look to restructure the most expensive portions, start to consolidate and work on a medium term plan to pay it down. Above 50 This is good debt because it is being used in the production of a stream of income or in high quality assets. You are well on your way towards financial freedom and independence.
Debt is Not Lucifer
Financial advisers are terrified of debt. Get out of debt NOW is their first word of advice – for which they will happily charge you a few hundred dollars. Let's put the numbers into perspective. The global debt or bond market is three times larger than the global equity market. Debt makes the world go round.
The United States Government has issued almost $30 trillion in treasury debt. If the United States treasury had followed the advice of financial advisers, it would be a failed state like Somalia and overrun by pirates and lawyers.
In the corporate world, Tesla is revolutionizing the automotive sector thanks largely to Elon Musk's vision and genius, but also thanks to debt. Tesla has access to the bond market and can fund its ambitious projects making use of other people's money. As of February 2020, Tesla had borrowed close to $8 billion with a weighted average coupon of less than 3 percent.
So why has debt been vilified? Sometimes, debt does not help itself out with the language it uses. Mortgage means “death pledge”. Semantics aside, there is good debt, there is bad debt and there is ugly debt. We will address ugly debt first.
In Colombia, there is debt known as "Gota, Gota" which means "Drip, Drip". This debt will suck every drop of blood from your body. Gota, Gota is a form of informal and illegal money lending that started in Colombia and then spread to numerous Latin American countries. Gota, Gota is popular because credit does not flow to all. No credit track record or track records worse than that of the English football team at the world cup exclude many from the credit markets. The loan sharks (the Gota, Gotas – not the English football team) charge interest rates above 30 percent per month which works out to an effective annual rate of 360 percent. These lenders employ creative debt collection techniques. The most common is the application of baseball bats to knee caps. I saw a picture of a Gota Gota late-payer. He had been hung off a busy highway bridge. At first I questioned this debt collection strategy. Dead South American men hanging off bridges are not wired to paying their debts on time. It was then explained that bridge hanging was exceptionally efficient debt collection. It dramatically reduced the probability of living clients missing their payments.
Now the bad debt, and it is not what you thinking - credit card debt deserves its own section. Bad debt is debt used to finance activities that do not generate any cash flow. For example, taking out a loan to go on holiday, or remodel your home or to increase/decrease the size of a body part. Finally, we have the good debt. This is the debt that is used to acquire assets that generate cash flows. A loan to buy an apartment or a piece of heavy equipment that is rented out is inordinately good. Good debt is a powerful tool in the attainment of financial freedom.
Special Note on Credit Cards
The first thing you learn in financial advisers school is to cut up your credit card. The reasons offered: credit card companies make money out of you, you are setting a bad example for your kids, credit cards are like the apple in the Garden of Eden and you do not need a credit card.
Firstly, credit card companies do not always make money from you. There are two payment options on your monthly statement. The first is the minimum payment. Credit card companies pray you choose this. It allows them to charge usurious interest rates disclosed in small print on page 89 of your contract. There is another option which is the payment to avoid interest. This is a thing of beauty. It will settle the balance at the cutoff date of the card. The cutoff date is normally ten days before the payment date. If your cut of date is the 20th, your payment date will most likely be the 30th. If you buy a Louis Vuitton bag on the 21st, you will only need to pay for that necessity on the 30th of the following month. You are the recipient of 39 days of FREE MONEY. I don’t care where you from, but that is a great deal. The banks make no money out of you in terms of interest. They may charge an annual membership fee but this is all the blood they will be sucking from your veins.
The second argument is you are setting a bad example for your kids. Teach them about the 39 days of free money and that bad example turns into a good example. It is your job as a parent to educate your kids financially because they will not get this at school. Buy them a copy of this book. Every member of every family should have their own copy – books are like swimming trunks, they should not be shared.
The third point is one of temptation. Credit cards present too much of a temptation. Whatever happened to self-control? At what point did self-control stop differentiating us from the wild animals? If your credit card is your biggest source of temptation, then you may have bigger problems.
The final point is that you do not need a credit card. This is just stark raving mad – you do not need two lungs, but you were born with two. You do not need wisdom teeth – they serve no real purpose – but most people are born with them and are a bloody nuisance to remove. I hate going to the shopping mall. My wife could spend an entire day there. After half an hour, I want to rip my eyes out of their sockets. Amazon, on the other hand, is god's gift to men like me and is best done with a credit card – add to this list Netflix, Spotify, and Uber.