The current issue of the Economist has as it’s cover article, “What will happen if Greece fails?” The EU is meeting now to review their plan of how to deal with the Greek debt crisis we recently discussed, and the Economist’s view is that their current plan cannot succeed. So what will happen? One disaster scenario is that the Greek debit crisis might actually precipitate the collapse of the entire EU experiment.
I’m on my way back to Canada (Vancouver) after a brief sojourn in Paris. But before I left for Paris, in the train station, I bought a copy of the Canadian version of MoneySense magazine (“Canada’s Personal Finance Magazine”). In it is a pullout section called “Debt 101: Mastering Your Debt.” So I thought as the world waits to see whether the EU will fail based on bad debt decisions, maybe we could look at things a little closer to home. Both in your personal life or for your business, when is debt “bad” and when is it “good”?
According to MoneySense, bad debt has 3 qualities:
1. It’s expensive
2. It’s not tax-deductible
3. Debt was incurred to buy a depreciating asset
Conversely, “good” debt has 3 opposite qualities:
1. Debt was incurred to buy an appreciating asset
2. The debt has a low interest rate
3. The interest is tax-deductible
So anyone who’s taking my logic course should take an interest in how I use quote marks around “good” and “bad”; there’s a reason for that. But for the rest of you, the short version is that what decides whether something is good or bad has nothing to do with the object itself. Is debt good or bad? Sometimes it’s good, sometimes it’s bad (and sometimes it’s both and sometimes neither). Which tells us then that there is no relationship between debt and being good or bad.
So what makes debt good or bad? The easiest way to measure is to look at the result: what did you get from borrowing? Say you borrow money to buy a house and eventually manage to pay off your mortgage. Then you’d say the debt was “good”: you borrowed money which allowed you to buy something you never could have afforded otherwise. That’s good.
But say you borrow money for a house and end up declaring bankruptcy, like so many Americans are doing now. Then you’d say that borrowing money was bad.
So how do you know whether borrowing money will end up being good or bad? MoneySense tells me that the Canada Mortgage and Housing Corporation recommends 32% of your income as the upper limit for home buyers. But does that help us? Do people who borrow less than 32% always fail to repay their loans? Or do people who borrow more than that never succeed? And if not, what good is that number?
I would say that number is useful in one sense: I said before that I think, from a mental seed planting perspective, it’s okay to borrow money if you have a reasonable expectation of being able to pay it back. “Reasonable” is a very subjective word, but I would say that if you borrow more than 32%, in this example, you have a tenuous hold on reasonable.
But the best answer is always, if I want to know if something will work, what do I have to do? Plant the seeds for it. How do I do that? Help someone else.
So… why are you borrowing? If you have a reasonable expectation to be able to repay the money, and you are borrowing to help someone else, then you’re using mental seed management. If you borrow money to grow your business, with the motivation that you can hire more employees to help them, so you can help more customers, succeed for your investors, and/or supply a better product—these are all good reasons to borrow money.
But if you’re borrowing money to get that bigger entertainment center, especially to watch more football games, because you enjoy them; or to buy tickets to go on vacation in Tahiti because Bob and Sue next door just got back from the Bahamas—maybe if you start to fall behind after that now you’ll be able to figure out why.