By: Kyle Prevost – a prominent personal finance writer and blogger (as well as an hounored educator) – writing for publications like MoneySense (Canada’s #1 investment journal) and ValueWalk, and is providing commentary in radio and mainstream Television (Linkedin profile)

The topic of good debt vs bad debt is one of the most commonly misunderstood concepts in building wealth today.  When the average layperson thinks of debt, they automatically associate the phrase with anxiety and negativity. But while debt has obviously caused many people substantial amounts of stress over the years, it is also a tool that almost all self-made millionaires have used at some point in order to grow their business and achieve success.

Because most of us didn’t take part in honest conversations about debt and money while we were growing up, it can be difficult to understand the nuances of how borrowed money can be used (or can use you) in various faucets of life. Even the math and unique vocabulary required to understand the impact of debt decisions can be difficult for people to wrap their heads around, especially if they shy away from asking questions because they don’t want to look stupid. 

The truth is that debt is just a tool. If you don’t know how to use the tool, it can get you in major trouble. But if you understand how to use financial tools like debt, it can really help you to build wealth efficiently.  

People get themselves into “bad debt” feedback loops when they borrow money to buy stuff that goes down in value as soon as it’s purchased. Think about a credit card-fuelled clothes shopping spree or a car loan for a luxury vehicle. This access to borrowed money allows people to briefly live beyond their means, but severely reduces future purchasing power as interest payments gobble up more and more of a monthly budget. Furthermore, when the negative debt spiral gets to be too much and a payment is inevitably missed, the consequence will be much higher interest rates going forward – thus continuing the destructive debt cycle that too many people find themselves in.

On the other hand, many successful business owners understand that once you have a successful business model, using borrowed money to grow your business as quickly as possible will result in positive feedback loops that supercharge wealth creation. If you are able to understand the details of how financing works, and have a clear plan of how the borrowed funds will help you and your business, then it makes sense to call it “good debt” right?

Good Debt vs Bad Debt for The Private Consumer

Before we dive deeper into what is good business debt and what is bad business debt, we should quickly look at good debt and bad debt as it pertains to private consumers.

This article from CNBC describes good debt vs bad debt based on the reason you were borrowing money. In CNBC’s Janet Alvarez’s own words:

“Good” debt is defined as money owed for things that can help build wealth or increase income over time, such as student loans, mortgages or a business loan. “Bad” debt refers to things like credit cards or other consumer debt that do little to improve your financial outcome.

Similarly, ABC repeats the notion saying that

“The really simple way of looking at it is: bad debt is debt that’s going to cost you money,” says Brenton Tong, a Sydney-based financial planner. “Good debt is debt that makes you money.”

While these quick takes are mostly correct, the problem is that financial situations are often much more “gray” than the “good debt vs bad debt” definition would indicate.

Student loans are an excellent example of borrowed money that can’t easily be classified as good debt or bad debt. My friend took on substantial debt ($50,000+) as he pursued his goal of becoming a dentist. Because he identified a career path that he knew would be quite financially rewarding, and then committed to fully completing his course of study, the student loan was unquestionably good debt for him.

On the other hand, there are numerous stories that come out every year (usually around graduation time) concerning the number of students who owe $100,000+ in student loans, and either have a degree that will not benefit them financially at all, or they did not actually succeed in attaining a degree or a diploma despite borrowing all of that money. In those cases, the student loan is unquestionably bad debt, and it is bad debt that will likely have a drastic impact on their life going forward.

In a recent interview, Michael Martin, the author of The Debt Trap: How Student Loans Became a National Catastrophe, provides some insights in regards to how deep the student loan crisis runs in America:

“There’s 8 million people, something around that ballpark that have defaulted on student loans. That’s not that far off from the number of people who lost their homes to foreclosure in the housing crisis. If you look at the number of seniors who have had their Social Security checks garnished in recent years, there’s more than a million people that have had their Social Security checks garnished because they can’t pay their student debt. And the government is garnishing their checks, reducing their Social Security checks to recover some of that debt. And in a lot of cases, parents are going to have this debt hanging over their heads, probably for the rest of their life.”

Clearly we should be having a much more detailed discussion about the intersection of student debt and career choices prior to young people making decisions that have such potentially radical long-term consequences.

Another difficulty with applying the “black and white labels” of good debt and bad debt to personal consumption, is that sometimes life requires us to responsibly use debt in order to consume. Perhaps a string of bad luck led to both your car and furnace requiring major repairs within a week of one another. What’s essential in these situations is that the terms of the debt are fully understood, and a plan put in place to repay the debt before the negative feedback loop begins to spiral downward.

Good Debt vs Bad Debt for Small Business, Sole Traders and Companies

The plain vanilla definition of good vs bad businesses debt can be found in resources such as the U.S chamber of commerce article is

…good debt for small businesses as money borrowed to pay for items that will contribute to the growth and development of their business… When a lender is borrowing money to purchase a depreciating asset that won’t go up in value or generate any income, that is commonly considered bad debt. Any loan or borrowed money that potentially can reduce your business’s future net value should be avoided. Some signs of bad debt include high interest rates, fees and strict loan repayment terms.

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Again, we see that while many people appreciate the concise nature of these quick definitions, when we apply this “black and white” logic to real life, it can be much difficult to determine whether borrowed funds are good debt or bad debt at the time the loan is granted. Assets purchased with the intent of growing a business can quickly prove to be less helpful than initially anticipated. Similarly, interest rates can change quite quickly, and make what was once considered to be good debt or even great debt, terrible debt over the long term.

Additionally there’s a bit of a clash with reality when it comes to access to finance. Small businesses that are looking to borrow money are often seen as quite a risk for the banks that are doing the lending. Consequently, the options might be limited to loans with relatively high interest rates. Does this mean businesses should avoid any and all financing (potentially looping themselves into a lifetime of “barely making it”)? Obviously that’s not ideal.

For example, if there is a small business which needs to take on immediate debt because they are required to buy a piece of machinery which is crucial to their day to day operation, then it is very hard to call that bad debt.  Sure, a 30-day loan from a specialized lender like Prospa might come with high interest and some financing fees, but if your business doesn’t function at all (no cash flow) without the piece of machinery, then the debt can’t really be considered “bad” no matter what the financing details.

Now, it’s worth noting that generally the larger and more well established a business is, the easier it is to make debt-related decisions. First and foremost, while directors of a corporation can have some limited liability towards debt, it’s not nearly the same as exhaustive as those of a small business or sole trader. This allows corporations to look at debt with less overall risk involved.

Secondly, established companies normally have years of data with which they can prove to lenders that they are a good risk for borrowed money. Banks have specific rules in regards to what types of businesses are considered more risky vs less risky, and subsequently, who should get the best interest rates (or even access to credit at all). Additionally, corporations have far greater access to financing than sole traders or small businesses (even those boasting a fairly good business credit score).

There are also companies operating in certain spaces in which financing is a “part of the game”, like construction. These companies whose line of business is reliant on external financing (such as construction loans or commercial bridging loans) have proven business models that help both sides agree in regards to what is good debt and what is bad debt.

Working With Debt for Your Business

Regardless of if you are running a sole trader (aka sole proprietorship) or a corporation, here’s a few things to keep in mind when considering whether or not it’s a good idea to take out a loan in order to invest in your company.

1) A business line of credit, a working capital loan, or other short-term financing is likely essential to the day-to-day running of your company. I wouldn’t just call it good debt – but I’d say it’s “necessary short-term debt”.

2) Pay attention to the interest rates on each different type of loan that your business takes out. Oftentimes long-term loans for land, buildings, or new equipment, come with much smaller interest rates than short-term financing (especially if it’s from alternative lenders) or business credit cards. Obviously you want to make sure that you pay off higher interest first.

3) When trying to decide if a loan is a good choice for your company’s expansion, really do your homework in terms of forecasting the cashflow that this new addition to the company will bring in. You don’t want to get caught in cashflow crunch where payments and interest start to accumulate before revenues from the new project begin to pour in.

4) Whether it’s personal debt or business debt, remember that if you’re making a “luxury feel good purchase” then you really need to look at the full cost of the item (including interest payments) and decide if the joy it will bring you is worth the debt burden.

5) Developing good debt repayment habits and a positive long-term relationship with a lender will be major assets to your company. Australian banks are known to be quite rigid with their credit and debt requirements. As interest rates go up domestically and globally, banks are becoming even more risk averse. Whether you’re working with a traditional bank or an alternative lender that specializes in credit for small businesses, the more you work together, the greater chance that your financial transactions will be completed in a smooth and timely manner.

A Quick Aside on Systemic Debt and Systemic Poverty

It’s difficult to write a primer on good debt and bad debt without addressing the social/financial connection that debt has throughout the world. One of the main reasons that people and SMEs alike are sometimes “pushed” into accumulating bad debt is that credit operations are usually quite profitable for financial institutions.

People and businesses that aren’t familiar with the subject-specific vocabulary, or are uneducated in how debt traps can occur, can easily fall into the negative feedback loops that we discussed earlier. Poor credit scores lead to higher interest rates, which lead to more day-to-day struggles that encourage more borrowing.

Here’s a quick look at some prominent examples of recent debt spirals that were/are so large, that they’re having outsidex impacts on the entire economy.

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From Chicago Booth Review about the 08 housing crisis:

In 2007, there were dramatic differences across US households in both the composition of net worth and leverage (amount of debt). Homeowners in the bottom 20% of the net-worth distribution—the poorest homeowners—were highly levered. Their leverage ratio, or the ratio of total debt to total assets, was near 80% (as in the example above with a house worth $100,000). Moreover, the poorest homeowners relied almost exclusively on home equity in their net worth. About $4 out of every $5 of net worth was in home equity, so poor homeowners had almost no financial assets going into the recession. They had only home equity, and it was highly levered.

From Brookings institution

…borrowers who struggle with student loans are different. Almost 90 percent of borrowers who default on a student loan received a Pell Grant because their income and wealth was low when they applied to college…

From Bloomberg about micro-loans for the poorest:

In Jordan, one of the few countries that still imprisons people for nonpayment of debt, more than 23,000 women were wanted by the police in 2019 for owing less than $1,400 each, Justice Ministry officials have said. In Sri Lanka, consumer-advocacy groups estimate 200 women indebted to microfinance companies committed suicide in the past three years.

Yet the World Bank, the European Investment Bank, the U.S. International Development Finance Corp. and other development banks continue to invest billions of dollars of public money. More has come from commercial banks and impact investors. Citigroup Inc. had lent about $1 billion to 89 microfinance institutions as of January 2020. Japan’s Sumitomo Mitsui Financial Group has invested billions of dollars in Asian firms, including in Cambodia. JPMorgan Chase & Co. sold a $175 million collateralized loan obligation in 2019 backed by microfinance and small-business repayments.

From UC Berkeley

One issue is that the banking system is not designed with low and middle class households in mind. At major banks, such as Wells Fargo, Chase, and Bank of America, 25 to 40% of checking accounts are simply not profitable and are described as “money losing.” To combat this, overdraft fees, debit card swipe fees, ATM withdrawal fees, wire transfer charges, among other charges and fees are imposed. These charges that appear around every corner of the banking system create a significant burden and barrier of entry for low and middle income individuals

and also

Banks, despite their image to the contrary, lack the stability that alternative financial services offer to low and moderate income individuals. Payday loans, money-lenders, and check-cashers oddly enough offer a level of stability and trust to low-income individuals that banks simply do not. In addition to undisclosed costs that pile onto banking services, there is a lack of personal service that for the wealthy may not be necessary but for the poor, makes all the difference.

From PolicyLink

… and the list goes on and on and on. Low-income individuals, as well as small businesses, are encouraged to accumulate debt because it benefits the high-income individuals and corporations. In other words, debt is systemic – private consumer debt more so than small business debt, but both are systemic. In fact, capitalism (if left unregulated and unchecked) reinforces poverty and the inequality trendlines are proving that.

Bottom Line: Good vs Bad Debt for Small Businesses and Individuals

So, if it can be difficult to define good debt and bad debt, or good business debt and bad business debt, where does this leave us in the decision making process? 

The fact that you may HAVE to responsibly use debt eventually means that should make the right preparations for a business loan application sooner rather than later. Similarly, as an individual it can’t harm to ask the right questions prior to borrowing.

Does it mean that as either an individual or a business owner, you should grab any financing you can in order to pursue any opportunity that comes along? 

Of course not.

My personal favorite book for understanding good debt, bad debt, and “gray zone/in between debt” is the classic Rich Dad Poor Dad by Robert Kiyosaki.  The author presents debt as a tool that needs to be understood – not a vague force to be intimidated by. In a very accessible manner (using a somewhat fictional or exaggerated narrative of the money lessons imparted to him by his two fathers) Kiyosaki explains that generally speaking, we can see that:

• Poor people use debt to buy nice things that they can’t pay for at the time.
• The majority of middle class people use debt to buy nice houses and cars that they can kind of pay for… if they are willing to pay a ton of interest along the way.
• Rich people use debt to buy revenue-producing assets. (Also known as “good debt).

Being a savvy personal consumer or somewhat effectively running a small business requires you to understand the principles of good debt vs bad debt.  However, being an exceptional small business owner requires you to be able to apply those principles to real life settings that aren’t always so simple and straightforward.