What is Bad Debt?

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What is Bad Debt?

Ben Leybovich
Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes

There's been a lot of discussion on the forums as it relates to differentiating bad debt from good.  The most common view on BP is that any debt which does not produce investment returns is bad debt.

I, for the most part, do not disagree.  However, there are caveats to this.  Before I state my definition, I'd like to take a pole.  Here we go - answer yes or no:

1. If you believe that so long as debt does not produce income it is Bad Debt - say YES.

2. If you believe that income-less debt could still be good debt - say NO.

What do you think?

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Elizabeth Colegrove
Hanford, CA · Member since 2013 · 5k+ posts · 1k+ votes
11y

I consider bad debt to be debt that is consumer debt things that you cannot afford. 

On the other hand, I don't think leverage things you would buy anyways a bad thing. Time Value of Money is very true. So taking advantage of that with 0% or low interest rates are awesome. 

For example, Buying a car that you were going to buy anyways and using a 0% interest rate. Taking that downpayment money and investing it into a rental. Now you have another rental who's profit covers much of that car payment. In my mind great leverage. 

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  • Ryan Dossey
    Real Estate Broker · Indianapolis, IN · Member since 2014 · 3k+ posts · 2k+ votes
    11y

    I think that it depends on the individual and their world view, self control, and goals. I have some "bad debt". I have a car loan. However it's 2.49 % on a car that I owe 10k less then it is worth. I utilize credit cards for the rewards. But I also pay them off every month. You have people that simply can't handle having "access" to funds. However they can also be very useful. It is recommended to have reserves however for someone just starting it can be a life saver. For flips they have uses. I do not think store cards are a good idea. In fact I think they are a terrible idea. Just like anything it is a tool. If utilized properly it can be a blessing. For some the temptation can be a curse. I value my credit score so I have never been late, behind, or paid interest. 

    1Reply
  • Julia Rowling
    Real Estate Investor · Greenville, SC · Member since 2014 · 76 posts · 23 votes
    11y

    NO....while I prefer to live entirely debt-free, I can see where investing in education *might* be "good debt", and also where if someone went into debt due to major medical bills, that would also be undesirable, but better than being sick...or worse.

    1Reply
  • Account Closed
    Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    11y

    I am comfortable with debt if I have sufficient assets to payoff the debt at any time. Ideally that would be not counting the equity in the real estate, but worst case including the equity (only if its > 30%). In no scenario ever would I have more debt than assets (aka negative net worth) no matter how much income the so called good debt was bringing in. 

    1Reply
  • Ben Leybovich
    OP
    Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
    11y

    Interesting - we are covering the gamut.  Anyone else have an opinion?

    0Reply
  • Andrew Davis
    Investor · Asheville, NC · Member since 2011 · 833 posts · 499 votes
    11y

    YES.... NO, I don't know!

    A home loan for a personal residence doesn't produce income in the classic sense.

    A 0% APR car loan doesn't either, but with inflation adjusted dollars you are paying less each month for the car.

    If the debt works to offset a tax obligation which would end up costing more than the debt, then is it really debt?

    I have always been of the mind that debt is only to be used for appreciating/income producing assets, but I'm open to being rebuffed.  It's a great discussion, interested to hear what others have to say.

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    11y

    Well, at least others understood the question, I need more clarification.

    Bad debt is debt created to cover expenses that don't create value. Allowing debt to accrue in place of, or the lack of, disposable income is bad debt.

    Good debt creates value and doesn't significantly reduce disposable income.

    So long as you can afford the debt, it might be good for you to take a vacation, you might be more productive. Only the one creating the debt can compare the pain inflicted for the benefits received, a good choice is hard to define other than as your opportunity costs.

    Debt that creates more income or value over the life of the debt is good debt, these are "earning assets". Debt that exceeds the value of an asset over time is a bad debt. Appreciation of an asset that exceeds the debt is good debt, an asset that depreciates and is less valuable than the debt is bad debt.

    Assets - Liabilities = Net worth, if your net worth increases you have good debt, if it goes down, that's not good.

    Don't know where you're going Ben, I guess toward leverage and use of funds, regardless, you can use that simple formula at any point in time to determine the proper use of credit and your money. :) 

    1Reply
  • Steve Olafson
    Scottsdale, AZ · Member since 2014 · 659 posts · 536 votes
    11y

    YES

    0Reply
  • Steve Olafson
    Scottsdale, AZ · Member since 2014 · 659 posts · 536 votes
    11y
    Originally posted by @Account Closed:

    I am comfortable with debt if I have sufficient assets to payoff the debt at any time. Ideally that would be not counting the equity in the real estate, but worst case including the equity (only if its > 30%). In no scenario ever would I have more debt than assets (aka negative net worth) no matter how much income the so called good debt was bringing in. 

    What if you had an opportunity to purchase a 10M building with nothing out of your pocket.  But you had to pay 10.1M for this building.  The area that this building is in has strong potential for future growth and has some cashflow now.

    Would you take this negative net worth asset?

    1Reply
  • Elizabeth Colegrove
    Hanford, CA · Member since 2013 · 5k+ posts · 1k+ votes
    11y

    I consider bad debt to be debt that is consumer debt things that you cannot afford. 

    On the other hand, I don't think leverage things you would buy anyways a bad thing. Time Value of Money is very true. So taking advantage of that with 0% or low interest rates are awesome. 

    For example, Buying a car that you were going to buy anyways and using a 0% interest rate. Taking that downpayment money and investing it into a rental. Now you have another rental who's profit covers much of that car payment. In my mind great leverage. 

    2Reply
  • Paul Ewing
    Investor · Boyd, TX · Member since 2014 · 688 posts · 467 votes
    11y
    Originally posted by @Elizabeth Colegrove:

    For example, Buying a car that you were going to buy anyways and using a 0% interest rate. Taking that downpayment money and investing it into a rental. Now you have another rental who's profit covers much of that car payment. In my mind great leverage. 

    My problem is I can't bring myself to buy a vehicle for over $5000 and even if for some reason I decided to bump that to $10,000 I can't see anyone offering me 0% on that.  Dealerships only offer those terms on vehicles that are sold for 25%+ more than their real value as seen in the depreciation when you drive it off the lot and it is no longer new.  Can we say literally Lonnie Deals on Wheels at the corporate level.

    2Reply
  • George P.
    Property Manager · Livonia, MI · Member since 2011 · 4k+ posts · 1k+ votes
    11y

    opposite of good debt.

    0Reply
  • Ben Leybovich
    OP
    Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
    11y

    @George P. - define good debt...

    0Reply
  • Ben Leybovich
    OP
    Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
    11y

    @Steve Olafson - you think like a creative finance guy.  You should be a guru - like me:)

    1Reply
  • Paul Ewing
    Investor · Boyd, TX · Member since 2014 · 688 posts · 467 votes
    11y

    @Ben Leybovich I was just listening to your CFFU module on this yesterday.  I also really liked you take on net worth being meaningless pat on the back.

    1Reply
  • Ben Leybovich
    OP
    Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
    11y

    @Paul Ewing - actually, my opinion is starting to evolve a bit.  Since virtually 100% of the folks who buy my CFFU are BPers, I figure the best way to make updates to the content, so to speak, is right here on BP.  That's pretty funny, actually, but it works very well.  

    I will state "the update" to my opinion before this thread is out, Paul :)

    0Reply
  • Brent Coombs
    Investor · Cleveland, OH · Member since 2015 · 6k+ posts · 2k+ votes
    11y

    'Bad' debt doesn't mean that you should worry unduly about it (due to circumstantial NEEDS or WANTS), but the main principle to apply is whenever you have opportunity to REDUCE debt, always reduce the 'bad' debt FIRST!  Cheers...

    0Reply
  • Account Closed
    Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    11y

    @Steve Olafson Nope. Because all your projections and forecasts are just that. There is no such thing as a risk free investment. And that would be outside my bounds of risk tolerance. If I had $3M to put down on a $10M asset AND that $3M represented less than 20% of my net worth, I would consider it.

    Now thats not to say I would not do the deal with no cash in. But my financial position would have to be the same. I'd have to have a $15M net worth to be willing to consider that deal.

    0Reply
  • Steve Olafson
    Scottsdale, AZ · Member since 2014 · 659 posts · 536 votes
    11y

    @Account Closed 

    We are very different people.  That risk would be very worthwhile to me and I would take it in a second.  :)

    I feel that unless there was a collapse that I could get backing if I needed it.  The potential gains with this deal would be too much for me to pass up.

    But, we are all different and have varied risk tolerances.

    1Reply
  • Account Closed
    Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    11y

    @Steve Olafson Yes, different strokes and all that. My very first foray into REI was a development project that was a "sure thing". All the numbers on paper made total sense. I should have easily doubled of tripled my investment in 2 years. This was in 2003. By 2009 I had not seen a dime of return, the project had huge delays and the market had moved enough to make it unprofitable. In the end LP's sued the GP and I got most of my money back...10 years later. Lesson learned. Things can and do go wrong.

    I think it also depends on where you are in life. I am very comfortable, make a great living and dont need the stress of added risk. I've also had the benefit of a fairly high paying career that I enjoy and have no reason to quit. If I was younger with less earning potential, I may be more comfortable swinging for the fences. So no judgement to those who take greater risks. But I think most risk takers do not really fully understand the risks until the poop really hits the fan. And this is true of very experienced business people as well as naive newbies.

    2Reply
  • Steve Olafson
    Scottsdale, AZ · Member since 2014 · 659 posts · 536 votes
    11y

    @Account Closed 

    Interesting story.  Development is different.

    I am a real estate person and have been doing this for many years.  I just sold a 14.5M deal in Houston that I had bought back in 2007.  I did not make much but my investors did. 

    I have bought managed and sold many multi-million dollar deals and feel a certain comfort with them.

    Depending on the circumstances, I would feel quite comfortable dealing with a property that size.  There are usually ways to make things happen barring a huge downturn like we had recently.  That is not something that we should have happen again in our lifetime though.

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    11y

    What was Ben saying about net worth being just a pat on the back?  Cough, cough, cough, ah, Ben needs some more school'n then. My gosh, the entire system would break down, I'm speechless! LOL

    Let's see how he evolves on his own. He's a smart guy......I think, he just needs to stay clear of that Brandon guy. :)

    Steve's example leave a lot out, to say "purchase" implies to me a period of time to pay it off since we are speaking of debt. That term is key, how long do I have to pay the full price.

    Saying nothing out of pocket, well, that premium is offset by the use of funds that would have been required, so that 10% is probably a bit less.

    That premium paid over a term is interest, so it is amortized over the purchase term as well. Interest paid or consumed doesn't add value to any property, which is to what I'm always saying, financing doesn't add value to a property. Paying too much is deferring appreciation earned in the future from ownership.

    Look at the term again and factor in appreciation due to the market, then again for forced appreciation.

    Now, I need to know if that property cash flows, even if it didn't eat any hay and paid it's own way, I take that deal any day as, according to my above post, that meets the good debt requirements. It's the deferral of the premium as interest that keeps the asset equal to or greater than the cost of acquisition, going by the rules. That premium to be paid is not realized until the allocation for the period has been passed or consumed. In other words, future interest due is not a liability but a contingent liability. The premium can be a footnote to your financial statement and your assets and liabilities remain the same. I assume over time the debt is reduced, the equity is gained and the premium is expensed. It's probably a deal that you don't want to payoff next year, but in time the outstanding premium due can be offset by appreciation.

    My only other concern would be the management, the value of my fooling with it over time, but at $10M, that's probably covered. :) 

    1Reply
  • Bryan Hancock
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    11y

    I wrote a post about optimal leverage strategies a long time ago on BP's blog that may add some to this discussion:

    Optimal Leverage Strategy

    The OP was about whether or not there can be circumstances where non-income-producing uses of debt are "good."  I understand the desire to caution Dave Ramsey watchers about "bad debt" and it seems very sexy to make a crusade against debt because so many people are irresponsible with using it.  In general I agree that financing non-income-producing assets with debt is less than optimal and in many cases is a poor decision.  However, one could play devil's advocate here on many things:

    • Unexpected medical bills.  I guess one could argue that this is really financing an income-producing asset though because without labor producing ability most people lose their number one asset
    • Transportation to get to work.  Vehicles are awful investments in most cases, but the utility of being able to get around is there for the first $X of an investment.  Skimping here could get you an unreliable car and force you to have poor performance on the job because you miss work or are deemed unreliable
    • Entertainment for investors is difficult to quantify

    I am sure there are hundreds of other examples here.  Rational people can probably disagree about the utility of spending money on various items of all sorts.  

    0Reply
  • Account Closed
    Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    11y
    Originally posted by @Steve Olafson:

    @Account Closed 

    "Interesting story.  Development is different."

    And that is how risk is rationalized. Its different! But actually its not. My point was that while I had a large chunk of cash in that development deal, it was not borrowed and did not represent a huge portion of net worth (although at that time it was a much larger share than I was comfortable with). If I had to pay interest on that to somebody for 9 years and possibly write off the investment, that would have hurt a hell of a lot more. It did create trouble for me in a sense because I planned on using that cash to buy a new personal residence. But still, keeping in my risk boundaries saved me many sleepless nights and was well worth it to me. 

    1Reply
  • Steve Olafson
    Scottsdale, AZ · Member since 2014 · 659 posts · 536 votes
    11y
    Originally posted by @Account Closed:
    Originally posted by @Steve Olafson:

    @Account Closed 

    And that is how risk is rationalized. Its different! But actually its not.

     I see that you look at this as right or wrong.  We all have our different tolerances.  I am doing just fine with my choices just as I am sure that you are doing fine with yours. 

    I have been bit.  I know what it feels like to lose a lot of money.  But I know how to make it as well so my fear level has definitely gone down. 

    0Reply
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    11y

    @Account Closed 

      in a LP suing GP scenario if you got almost all your money back then you came out better than 99% of others who have been in GP or syndication deals that turtled.

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