Good Debt-Bad Debt


Recently, Lawrence, a reader from Canada, asked about the advisability of borrowing money to buy an electric car. Lawrence read one of my books where I explain the debt rule: Don’t borrow money to buy a depreciating asset. However he reasoned that the thousands that he would save on gasoline would make it worthwhile. This got me thinking about when, and under what circumstances, there might be an exception to the debt rule.
First, let’s start with the concept of ‘good’ debt. Good debt would be any debt used to purchase something that would provide a current and future benefit and have a reasonable chance of appreciating in value from debt consolidation companies. Perhaps the most obvious example would be the purchase of a home. Certainly buying a home meets the ‘present and future benefit’ test. However, the collapsing housing market may have people wondering if purchasing a home meets the ‘appreciation’ test.    On a short-term basis the answer is situational…meaning that, depending on your particular situation, you may find that your home is worth less than what you paid. However, long-term home ownership remains a worthy financial strategy and, while it may take several years, we’ll see rising values in the future.
Borrowing money for investment can also meet the test of ‘good debt’. Consider purchasing a duplex for $100,000 cash where net income is $15,000…or a 15% return on your investment. If instead of paying all cash, you borrowed $65,000 at 6%, your return jumps to about 30%!
Borrowing money for education is another area that could qualify as good debt if the result is a better paying job.
Let’s get clear about what bad debt looks like. My favorite example would be borrowing money, typically on a credit card, to pay for a vacation. While ‘fun’ might be considered a current benefit, this will fail the ‘future’ and ‘appreciation’ tests. The same applies for borrowing for entertainment, furniture, clothes or gifts. Clearly, you’ll want to figure out how to save and pay cash for these types of purchases.
So how should we advise Lawrence who’d like to purchase an electric car but will need to borrow money to do so? If you are going to knowingly violate the rule, make sure that you have a source of income to pay for it. In this case I’d advise Lawrence to finance the car over no longer than twenty-four months and plan to keep the car for a long time, say ten years. This will give him more time for the ‘savings’ from the electric car to bear fruit. I do have a couple of concerns he should consider:
  • The driving range for an electric car is 75 to 100 miles on a single charge so its usefulness is limited. If he has longer trips in mind, he may need two cars and this may negate any savings.
  • An electric car will depreciate just like any vehicle, but I have a concern the electric car may depreciate faster than its gasoline counterpart.
My best advice for Lawrence is to see if he can purchase a used electric car…one that still is in manufacturer’s warranty. He’ll likely shave a minimum of 20% off the purchase price and still reap the lion share of the future benefits.