Financial Literacy

Is Debt Bad and Should It Be Avoided at All Costs?

If you have some debt, should you pay it first or should you try to invest your way out of it? Is debt good or bad?

Generally speaking and as noticed in the “defining asset vs liability” post, debt is not inherently good or bad, it’s mostly about how it’s used. At the end of the day, debt is just leverage and you pay a premium to use that leverage in the form of interests.

Therefore, from an economic perspective, it usually only makes sense to use this leverage if the benefit of this leverage outweighs the cost of the premium. More simply said, if you borrow money at 5% per year and you’re pretty sure you’ll make a 10% or 20% return on that borrowed money it’s certainly worth it. However if the returns were only 3%, the cost of the debt would be higher than what you’d earn and it would probably not make sense from an economic standpoint to contract such loan.

So in the end, using debt to acquire cash flow performing assets is definitely worth it if the returns are higher than the cost of servicing the debt. But otherwise it should be avoided. Using debt for regular consumption is probably the worse type of debt one can contract, since the returns on consumption items are usually 0%: that new appliance or that fancy dinner will not make you any money.

A note on education: the current outstanding student loan debt in the US is now over $1.6 trillion. And many people are stuck in a job that does not allow them to service their student debt burden. Worse, as of January 2020, student debt is not dischargeable in bankruptcy and you may be stuck with your student debt for life. So for any student looking for a student loan, it’s probably wise to check what’s the salary one can expect out of college to assess how much debt is reasonable.

There are several websites to check how much one can expect for a given job:

Having, let’s say, $50,000 of debt out of Med school to be a physician is probably reasonable, ditto with a Computer Science degree to be employed as a software engineer (at least in early 2020), as these jobs tend to earn at least six figures out of college, but it is not the case for many other degrees.

It may all sounds like common sense, but it’s important to absorb and never forget the fundamental economic mechanics of debt, because it’s easy to get tempted by a fancy new appliance, house or college degree that could put an enormous drag on your finances and delay your financial freedom by several years if not forever.

But what if you already have debt? Should you pay it first or invest your way out of it? Well, every investment carries some risk and the money invested can be completely lost. On the other hand, the debt you pay down, is a guaranteed balance payment you won’t have to service anymore. Therefore, it’s usually more advantageous to pay down existing consumer/student loan debt.

But debt at the end of the day is leverage, and leverage carries risk. And carrying risk over an extended period of time is something to be dealt with carefully.

So, how should you go about paying it off? Have a look at the Fastest Way To Pay Down Debt.