Good Debt vs Bad Debt

 

A lot of people think that if you want to be financially free then you should be free from debts too. They are right to some extent, if you are free from the debts then whatever extra cash that you have can be used solely for investment. This is an ideal situation.

Unfortunately the world is not an ideal place, most people in their quest for zero debts will have no excess (or very little excess) left to do any investment to generate passive income. Most of their cash are locked up in their house and cars.

So, not unlike cholesterol there are actually good debts and bad debts.

 

In general, any debt that has lower interest rate than your investment return is a good debt.

Let's say you have a housing loan debt of RM200k. Life is hard and you can barely make ends meet. You have very little savings. Unexpectedly your long lost aunt died and left you $200k.

 

Your housing loan interest rate is 6% p.a. Unit trust gives a consistent return of 8% p.a.

Should you settle your housing loan with your windfall? Or should you invest in unit trust and use the return from the investment to partially support the loan instalment?

The logical choice is of course the latter because the housing loan is a good debt so why do you need to settle it?

Some of you may disagree and would prefer a "peace of mind" over common logic. You would rather pay off the debt so that nobody can take away your house. That is a fairly good reason actually.

My challenge is what if the economy turn for the worse and you lost your job? Your cash are now tied up to the house which cannot be easily liquidated most especially during economic downturn.

On the other hand, if you were to choose the second option, you will still have the $200k that generates 8% return per annum. Even if you lost your job you can still easily service the loan using the money and feed your family while searching for an alternative employment.

Another common reason why people in the above scenario will tend to fully paid the loan is because they are worried that they will spend all the money and ended up neither here nor there. Still in debt and have no savings either.

This is a bit tricky. There is no magic formula to cure lack of discipline unfortunately. Even the best laid plan will go awry if there is no resolve to follow it through.

 

Emergency fund should not be touched in any circumstances except the loss of employment. Investment fund should only be withdrawn for the sole purpose of reinvestment.

So before you go on this journey, it is imperative to make sure that you have a strong will to carry it through. Shaky resolution will get you nowhere.

Let us revert back to the example. What if the housing loan interest rate is 6% p.a. but the cash-like investment can only give you a consistent return of 4% p.a. or lower?

Under these circumstances the debt can be considered as bad debt. If we were to consider only the obvious then by right you should use the inheritance to fully settle the loan.

However, since you don't have any emergency fund I will not advise you to fully settle the loan. Maybe set aside some money for emergency fund and use the rest for partial settlement.

Please note that this is just a simplified version of the real world. In the real world, life is not that black and white. It is rarely that straight forward.

 

Situation changes all the time. Maybe due to some changes in the investment climate, the unit trust fund may give more robust returns in future years.

I still remember the time when interest rates for housing and car loans were sky high back in mid and late 90s. Now they are quite low. It might change again in the future so good debt today may be bad debt tomorrow.

The key is to be vigilant and take action appropriately depending on the situation.

 

Homework: Go through your current debts. Determine whether they are good or bad debts. If they are bad debts, how fast can you pay them off? Devise a plan and take action!