The good, the bad and the subprime

Debt finances the construction of mega-structures, innovation, many unnecessary wars, and the rapidly-cooling latte of this not-so-humble smashed avo enthusiast. Debt in its traditional sense is often shunned by millennials. We no longer have faith in our financial institutions. We’re no longer naive enough to believe the narrative that banks are acting in our best interests.

But not all debt is bad.

Young people think debt sucks because it stands in the way of financial freedom. And it does. Debt impedes your cash flow. Your fortnightly income is substantially reduced by the repayments you’re making on your car, your mortgage or your credit card, and you don’t even realise it. But there are different types of debt. It’s not very relevant for example that interest and other expenses (assuming these costs don’t increase) on your investment are impeding your cash flow if the income your investment is generating is higher than these costs (something we call positive gearing). It may also not be too relevant to you that these costs are impeding your cash flow if you’re making a good capital return on your investment (i.e. the value of your investment is improving at a higher rate each year than your costs).

Good debt

Good debt is debt you can use productively to improve your life. This is the type of debt that might hurt you the least. Good debt typically has at least one of these four characteristics:

  1. Good debt helps you earn money – whether by way of income or capital growth.
  2. Good debt helps you upskill yourself.
  3. Good debt is sometimes tax deductible.
  4. Good debt is secured (ideally against an asset which appreciates in value).

A university or college loan is an example of good debt. In Australia, a university loan is often referred to as the best loan you can take on. And with good reason. It doesn’t accrue interest and is instead indexed with the consumer price index (a measure of inflation which I talk about in Economics 101). Further, the debt is being taken on for educational purposes and in many cases will help you kick start your career. A university loan in Australia may be tax deductible, in limited circumstances.

A business loan is another example of good debt. Most businesses have high outlay costs and most people require additional financing to afford such large expenditure. You will have taken on a business loan because you intend to grow a clever idea you may have into something lucrative. Further, the interest payable on a business loan may be tax deductible.

A mortgage on a residential property, particularly an investment property, is also an example of good debt. It’s either debt you’ve taken on to fund a necessity (i.e. shelter) or debt you’ve taken on to increase your wealth in the long term. The benefit of a mortgage is that a) in the majority of cases, people don’t hold enough cash to purchase the property mortgage-free; and b) if a) is true, you’re increasing your exposure (a concept we will discuss in detail in a later article) to any returns you make on the property without actually needing to hold enough capital to buy the property outright. Finally there are many tax incentives for holding an investment property (this topic also deserves an article of its own).

Bad debt

People take on this second category of debt to go on holidays, buy cars and ‘invest’ in cryptocurrencies (so they can exchange digital currency for… something, and consume more energy than the Republic of Ireland in the process). Bad debt is the type of debt that might hurt you a good amount, but not so much as any outstanding subprime debt you might have (see below). A personal loan is an example of bad debt, for two reasons. 

  • Firstly, personal loans are examples of loans where we start to get into double digit rate territory – i.e. the interest rate applicable to your loan is more than 10% p/a. It’s quite difficult to achieve a 10% return on an investment on a consistent basis so it’s quite difficult to justify paying such a high interest rate to your bank. 
  • Secondly, most people take out personal loans to spend on something which depreciates in value (such as a car) or on something which has no (monetary) value whatsoever once its limited utility has run dry (such as a holiday). I’m certainly not trying to argue that such spending isn’t necessary, I’m simply trying to explain that such spending is not worth 10%. The only reason why it might make sense to hold such debt is if you’re confident you can consistently return better than 10% with any cash you may have. Most people (including myself) would be better off not taking on the debt and instead saving money to finance such large purchases by adopting disciplined budgeting habits (sorry banks).

Subprime debt

Subprime debt is z-grade debt. It includes loans you give out to people with very low credit scores (and as a result attracts very high interest rates). It’s the type of debt which led to the events of the global financial crisis. It’s not debt you want to have.

I’m obviously not really going to talk about subprime debt here (since you’d hope this form of lending is now tightly regulated), I just thought it was a funny term. For our purposes, it just means awful debt. It’s the type of debt that might hurt you the most. Credit card debt is a perfect example. The interest that accrues on credit card debt is often ridiculously high and a lot of credit card debt is used to purchase discretionary goods and services which do not appreciate in value (e.g. birkenstock sandals).

A payday loan is also an example of awful debt. Payday loans are very common in the US of A but that’s not to say they can’t be found elsewhere. Pay day loans are short term and very expensive, in the sense that the interest rate chargeable on payday loans is stupidly high. They’re often targeted at people with low incomes or people in financial distress. In July 2019 the Australian Securities and Investments Commission released a consultation paper proposing to use its product intervention powers in relation to “short term credit”. The TL;DR version is that ASIC is investigating payday lenders charging almost 1,000% interest.

Debt has almost become taboo language among young people. The truth is we need debt to function as a society and most successful people would not be where they are without having taken on some degree of debt. We’ve discussed above how you can distinguish between debt that might benefit you and debt that will probably detriment you and I hope this has empowered you with the tools you need to make smarter decisions about debt.