Debt is a problem for many Americans, but the issue is not necessarily the concept itself, but rather, it is how loans are frequently misused, satisfying a materialistic desire instead of growing your wealth.
Let's start with a definition. Debt is an obligation that requires one party, the debtor, to pay money to another party, the creditor. In most cases, the debtor must pay back the initial amount (principal) along with additional amounts in the form of interest or fees. Debt can take various forms, such as loans, bonds, mortgages, or promissory notes, and can be for short or long durations. Debt can carry a high or low interest rate.
Strictly speaking, debt is a financial tool, nothing more.
When Debt is Good
Arthur Laffer is a supply-side economist. He was an adviser to President Ronald Reagan, and Laffer's policies helped to bring about one of the most prosperous economies in U.S. history.
Laffer asks this question. If he found someone who would loan you any amount of money at 1 percent interest, and he found an investment that guaranteed a 15 percent annual return, how much would you borrow?
The answer is that you would borrow as much as you possibly could, all of it, because you are guaranteed to make 14 percent on the loan.
In this case, the more debt you held, the more money you would make.
Laffer was specifically talking about national debt, but the idea can certainly apply to personal finance, too.
When is Debt Bad?
Debt is bad —dangerous, if you will— when it harms your personal financial circumstances and enslaves you to monthly payments.
Consider the example of credit card debt. While credit cards are convenient and even rewarding when used judiciously, they can quickly become a trap for the unwary.
If you rack up a significant amount on your card for non-essential items, like splurging on the latest fashion trends or frequent lavish dining, the repercussions can be long-lasting.
Not only will your future self be constrained by the necessity to allocate a chunk of your income to clear the debt, but the real cost of those purchases will also skyrocket because you will be repaying the principal and interest, too.
Proverbs 22:7 puts the idea this way. "The rich rules over the poor, and the borrower is the slave of the lender." (ESV)
This poignant verse underscores a critical reality. Being in debt, especially when it's beyond one's means, creates a dynamic of obligation, almost servitude, to the lender.
The Debt Rule
Use debt to purchase assets and pay upfront for everything else.
This rule can be instrumental in helping you discern between judicious borrowing and potential financial pitfalls.
For example, home mortgages are almost always considered "good debt." The rationale is simple. A home is a tangible asset that, in many markets, appreciates over time. A mortgage enables individuals to purchase a home and, over the years, build equity in that property. The tax implications of mortgage interest can also provide financial benefits in certain jurisdictions.
Similarly, taking on debt to fund business endeavors can be prudent if the anticipated return on investment outweighs the cost of borrowing. A successful business can generate consistent revenue and profit, making the initial debt a worthy investment.
But things like consumer credit cards, student loans, and even automobile loans can be forms of debt that weigh down your personal finances.