Our Money Vikings book includes an early discussion on debt, because that is how most of us start out on our financial voyage, in debt. Not many people have parents that support all their college expenses for years on end. That is the condition of a small privileged few.
This is not to say that all debt is “bad”. Most of us need to use debt or leverage to buy real estate and fund college degrees, things that can be assets over long periods of time.
Managing Good vs. Bad Debt
“Debt, an ingenious substitute for the chain and whip of the slave driver.” Ambrose Bierce, 1860’s
There are really two kinds of debt generally speaking. “Good debt” that helps us build wealth over time and “bad debt” that destroys wealth. The average American has $47,000 in school loan debt, $28,000 in auto loans and almost $7,000 in credit card debt.
The ideal of course is to minimize debt in general. Servicing debt monthly funnels money away from saving, investing and purchasing other assets. And the interest paid on debt is the opposite of the compounding returns that can be gained on investments.
That is $82,000 in the hole working against a person’s ability to build wealth. The school loan debt may be required in order to obtain higher quality employment. At a 10% interest rate for all this debt, it might cost a person another $8,200/year to service the debt. You can see how this can quickly become a debt spiral which rhymes with death spiral.
I have worked in real estate investing for many years. If you work in real estate you know that debt can be used as a powerful wealth building tool. When I started investing, I did not have $300k laying around to invest in real estate. I needed the leverage provided by a bank. Therefore I went and obtained a low interest loan to fund the purchase of rental property.
Good debt is commonly referred to as leverage. You see, in the world of physics leverage helps us become stronger with less up front power. When we use debt as leverage, as is the case in real estate sometimes, we are using small amounts of up front capital in order to gain more capital in the future with the same asset.
Even so called “good debt” needs to be managed properly so it does not become toxic debt. One example is school loan debt that has become astronomical in the US. An investment in an education can be a powerful life changing step, but the debt levels and ability to service the debt must be taking into consideration.
So in general, we all strive to be debt free on the path to financial independence. Debt is a kind of slavery or indentured servitude. Most of us at some point will need to take on some debt to address some pressing need. But there are several things that are not pressing needs: Fancy clothes, that tropical vacation, the expensive dinner out, the concert tickets, the kitchen remodel, the high end new luxury car. The person buying these things should be able to pay for them. Otherwise they are best avoided.
When these things are put on credit cards and not paid off, this leads to a toxic debt cycle. It is like the Borg from Star Trek or being sucked into a vortex, it is very hard to climb out. It is wise to avoid debt for these things completely and only do them when you can actually afford it.
The reality is that your life is complete as it is in many ways. We tend to think we need all these nice to have luxuries, but these luxuries end up costing us a lot of life energy and time.