When Is It OK To Take On Debt?
You’ve heard it said: “There is good debt and there is bad debt.” Perhaps this has caused you to wonder how any debt could ever be good at all! Some debt is certainly worse than other debt, but what factors separate bad from good?
Debt and the decision of whether to take it on can often be stressful. Relax. The following information will hopefully bring you more clarity as you consider debt, leading to a more knowledgeable approach to debt in your everyday life. This will help you better determine when it might be okay to take on debt in your own personal life.
How Can A Debt Be Good?
Calling any debt inherently good is a stretch. Being debt-free and having cash ownership is always better than having a debt. Therefore, I would just as soon wipe out the “good vs bad” debt discussion and instead put the various kinds of debts on a spectrum from “bad debt” to “cash ownership.” Viewing debt this way helps us see the cost of our debt in comparison to outright ownership rather than simply comparing it to another debt.
At the same time, leveraging debt can sometimes be a practical and reasonable path to move forward financially. With that, there is a frequent misconception that the Bible claims having a debt of any kind is automatically sinful. This is not found anywhere in the Scriptures. Debt, however, can often be the result of poor stewardship of God-given resources. The Bible also makes it clear that we should be compelled to repay all our debts (Psalm 37:21) and warns of how slippery a slope taking on debt can be.
Furthermore, the banking system and financial instruments of our day and age are drastically different than during biblical times. In many ways, this makes it especially important to approach debt carefully and with a calculated plan. Debt that holds the following characteristics is typically going to be easier to repay and manage effectively:
Secures An Appreciating Asset
It’s generally better to go into debt for something that is likely to increase in value as opposed to decrease. This will enhance your ability to repay the loan and avoid being underwater on it (when the amount of the loan is greater than the value of what it helped procure). If the loan was an investment in human capital then it should increase your earning power and thus your ability to repay it in full.
Our modern tax system partially offsets the burden of some debts in the form of tax deductions or even credits. Oftentimes, the anticipated tax savings are factored into the total interest expense to calculate what’s called the effective interest rate.
Low Interest Rate
All else equal, the lower the interest rate the “better” the loan is. A lot goes into why different kinds of loans can vary so drastically in their interest rates. Your credit score and what’s collateralizing the loan are generally the two biggest factors determining the rate. Be especially mindful of promotional interest rates that start low, but are scheduled to balloon later on.
The most common examples of these more favorable debts are loans that help you purchase a home, earn a degree, or start a business. In all cases, the investment is in something that is expected to appreciate. They also have specific tax advantages. Mortgage and student loan interest is typically deductible from income tax. Owning a business also comes with its own rap sheet of tax benefits.
As we’ll discuss later, just because a debt comes with some benefits or is more attractive than other debt doesn’t automatically make it justifiable. These debts still must be calculated against reasonable expectations and with extreme caution and care.
What Are Bad Debts?
While I’ve argued that no debts should really be called “good,” I certainly believe some debt can be bad or even downright nasty debts. Debts with the following characteristics are especially burdensome:
We’ve discussed the time value of money in various posts on this blog by calling out the tendency for wealth to grow in an accelerating trajectory thanks to compound interest. Well, the reverse is also true when it comes to debt. The longer a debt goes unpaid the faster the total debt grows.
High Interest Rates
Similar to time, the higher the interest rate, the faster the debt will grow, and the more costly it will be to pay off.
The easier the access to debt the more likely it is to cause impulse and unnecessary purchases.
Credit card debt is the most classic example of bad debt. It compounds continually and at outrageous rates, often 15-20% or more! Credit cards load you with spending power and put it at your fingertips, making it easy to overspend.
Let’s look at an example of how quickly credit card debt can get out of hand. Imagine $4,000 of credit card debt is amassed at 18% interest. Furthermore, the carrier of the debt is only able to make the minimum monthly payment of $80 per month towards paying off the debt. In the end, the debtor will pay a total of $7,520! That’s nearly twice the original principal balance just in interest alone. Additionally, it will take almost 8 years to repay.
This is a bad debt, indeed. Proverbs 6:5 gives good imagery of what it takes to get out of debt by describing a gazelle fleeing from its hunter. Equate this to the journey out of debt. This is especially true with credit card debt as in the example above.
When To Take On Debt
We have now established that debt is on a spectrum of severity and how problematic it is. Let’s put it all together in order to answer the question: When it is okay to take on debt? First and foremost, debt should only be taken on if there is a conservative and reliable plan to pay it off. From there, other characteristics of when it might be okay to take on debt are as follows:
You are acquiring or investing in something that is likely to appreciate over time. Examples include real estate, education, and starting a business.
You can afford to carry the debt if and when the unexpected happens. Having reserve funds or some other kind of back-up plan is an important part of managing debt.
You’re taking on debt at a lower interest rate in order to satisfy a debt on a higher one. This can be as simple as refinancing to a lower rate but can take on other forms as well. Say, for example, you have saved $10,000 for a new vehicle and are now ready to make a purchase. While you’re prepared to pay cash for the vehicle, you find out that your bank will offer a low interest rate of 2.5% on an auto loan. Meanwhile, you have a $10,000 student loan with 7% interest. You factor in the value of the tax deduction from the interest on the student loan and determine the effective interest rate is more like 6.5%. Because the interest on the vehicle is much lower than on the student loan, the best thing to do is to use your cash to pay off your student loans and then finance the vehicle. In other words, the opportunity cost of the lower interest loan makes it the reliably more favorable option.
Virtually everyone, at one point or another, takes on a debt of some kind. It’s important to remember that having debt is not wrong or sinful in and of itself. What is important is that there is a plan for paying back the debt and that the plan gets followed. A plan is what puts you on offense with your debt, rather than on defense by simply trying to keep up with payments. It is also important to very carefully consider the reasons for going into debt and whether or not it is wise stewardship of your resources.
Guide Financial Planning helps you take a comprehensive look at your budget alongside your assets and liabilities. We can help you build a God-honoring plan for your finances and for any debt you are carrying or considering. Reach out today for a free consultation!
About Guide Financial Planning
Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner™ and Certified Kingdom Advisor®. He has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.