Thursday, March 12, 2009

Bad Debt, Good Debt, Best Debt? How About...NO DEBT!!!

Debt seems to be something on a lot of people's minds these days, with many thinking about taking on additional obligations due to the low interest environment we're in. Others are more worried about eliminating debt, concerned with the downward trend in the overall economy. Either way attitudes toward borrowing money are changing, so I thought an examination of debt might be of some interest.

Leaving aside the question of the bigger economic picture for the moment, debt can be divided into three basic categories: Bad, Good and Best.

Bad debt is easy to identify, with the degree of "badness" determined by the interest rate. Bad debt can be categorized as any money borrowed for the purchase of something that will decline in value over time. A prime example would be a car loan. Fully financing the purchase of a $25,000 automobile results in an immediate loss of about 10%...within five years the vehicle is worth maybe $10,000 if you're lucky. High interest credit card balances are obviously the worst, with the purchases often related to goods and services with zero residual value.

Good debt by contrast relates to borrowing for the purchase of things that will increase in value over the years. The best example is of course a home purchase. Home ownership is a common goal in Canadian society, and one which makes a lot of sense. It costs money to occupy a residence regardless of whether you rent or why not have that occupancy cost go towards building equity. For many people their home represents their greatest source of wealth, and a retiree with a paid off mortgage has a number of options available should the need for capital arise.

Best debt is a concept that will probably be foreign to some. Like good debt it relates to the borrowing of money for purchases which will increase in value...but with a kicker. With best debt the commodity being purchased qualifies the borrower to write-off the interest expense on the loan. For specifics you need to talk to a financial advisor, but it typically relates to the purchasing of equities such as stocks or even mutual funds.

You may have heard ads talking about 'the tax free mortgage', which relates directly to the concept of 'best debt'. As an example, a person who inherits $25,000 could use the money to pay down a mortgage, then turn around and leverage against the equity in the home to invest in the market...with the interest payments on the loan being tax deductible.

Now that I've covered off the three basic kinds of debt, its important to get a gauge of the general economy. For the overwhelming majority of people, (excepting those who were around in the 1930's) an inflationary environment has been the norm. Inflation encourages people to spend, because over time the money in our pockets decreases in value. Looking for a new car? The one you want will likely cost more next year, and if not next year then certainly the year after that.

While inflation may scare people, its actually a sign of a healthy encourages the circulation of money, which in turn creates wealth. We've been seeing public sector unions negotiate some pretty sweet contracts recently, in spite of the downturn in the economy. Part of the rationale is an effort by governments to stave off deflation, which is far more devastating to the economy than inflation.

Deflation is something being talked about more and more, and while our gut reaction may be..."Hey GREAT!!! Things are getting cheaper!" it is something we should actually fear. Falling prices discourage economic activity, and decreased economic activity leads to a spiral of job losses. When people fear for their jobs, and when prices are dropping...people hang on to their cash. While prices are dropping the value of the coin in your pocket actually inflates, its an inverse relationship. That $100 bill in your pocket will be worth more next week or next year than it is right now, so hang on to it.

So now its time to look at our crystal balls, tea leaves...or to consult the trusty Magic 8 Ball. If you're of the opinion that the economy is going to continue struggling for some time, then it isn't a question of bad versus good versus best debt. In periods of deflation the best option is NO DEBT.

Almost every expert and guru out there...they're all predicting that we'll eventually see things turn around and that growth with return to the economy. The question though is when. I know there are people out there anxious to jump in while prices are depressed, with an eye toward catching the bottom and quite possibly making a killing, be it in the stock market or with a home purchase.

I am going to suggest that the best strategy right now is to eliminate as much debt as possible, and/or saving as much as possible. That way when the ultimate decision is made to invest, the need to borrow will be, if not least reduced. One might decide that now is that time, and I wouldn't disparage anyone bold enough to make that call. But if the money being used to dive into the market is borrowed, and if this deflationary cycle continues...then there's serious potential for dire results to one's net worth.

The bull is hiding right now, hopefully he won't be away too long.

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