The Differences in Debt

Differences in debts

Debt is one financial matter that fills me with dread. The prospect of owing someone else money is like a crushing weight on my soul. But that being said, debt can, at times, be a good thing.

I classify debt into three categories:

  1. Debt that does not add value.
  2. Debt that adds value.
  3. Debt that does not add directly add value, but is necessary, or has the potential to add value.

First, let me clarify that by “value,” I mean some intrinsic financial worth. Not the kind of value that you get when seeing the joy in your kids’ eyes while opening Christmas gifts.

Debt that does not add value is destructive. That new car is not increasing in value; it is depreciating. I know what you’re thinking, “Dude, I love my car, and I need it to drive to work, so it does have value!” Consider my ₹8,00,000 car loan that I took out last year. I’ve diligently been making payments every month, so my liability has decreased. Unfortunately, cars don’t last very long, and the resale value is decreasing even faster than I’m paying it off! This means that even if I were to sell it today, the best I could hope for is to make enough to pay off my loan.

Debt that does add value can actually be a good thing. Most people who open a business do so with the help of a loan. Ideally, the business will begin to make money, and the business will be worth more than the value of the loan. There are many examples of this constructive type of debt. But the idea is that you get a loan for the purposes of making money. This is leverage and thus needs to be used with care. However, if you know that you can borrow money at 6% and you know that you’ll make 8% off of the investment, then you’ve just earned 2% on money that didn’t belong to you. Even better is that (at least in India), you can deduct the interest from investment loans!

The third type of debt lies somewhere between the previous two. For example, taking out an education loan does not immediately provide you with a return. For the four years (or two, or ten, …) that you are in school the loan money does not provide you with a fiscal return on your investment. But in the end, when you get your high-paying job, it does reveal its benefit.

I will also place in this category the most common debt, your mortgage. Many people claim their home is an investment, and therefore it is constructive. I disagree;

  1. You make mortgage payments out of your own pocket rather than having the investment pay for it;
  2. You would not likely sell your ‘investment’ because where would you live;
  3. In India and the USA, these payments can be used against taxes. However, this is not the case in many other countries, such as Canada.

Don’t get me wrong; homeownership and mortgages can be a good thing. I simply argue against it being a constructive debt.

So my goals in order of importance to me are to:

  1. Eliminate all destructive debt.
  2. Reduce necessary or non-value adding debt.
  3. Make use of constructive debt where prudent.

I’m sure most people would agree on the first item.  However, it is the last two points that will draw a lot of contention.

In the past few years, people have been loading up the mortgage debt to the point where they can afford little else – all in the name of home-ownership.  25-year mortgages have now become almost commonplace so that you can retire in debt.

With the low cost of borrowing, even so-called constructive debt is running rampant (leveraged buyouts, etc., and included in this).  Corporations buying another or an individual buying any arbitrary stock with debt simply because it’s cheap will certainly be sorry once rates rise and/or the company’s finances crumble.  That is why I say use leverage when prudent