What is a good debt?

Many financial types, especially those who operate in the property space, talk about good debt.

Debt that is used to buy assets that increase in price is described as being good.

It’s good because you can buy more assets sooner than otherwise would have been the case, and can basically become richer than you otherwise would have been, without taking on debt.

This position is true at a limited individual level at certain points in time, but it is incredibly selfish, shortsighted, dangerous and ignorant of the effects that increasing debt has on asset prices.

It is certainly true that if one individual out of 10 were to take on debt to purchase an asset, such as a property, then they would likely increase their own individual prosperity above others who haven’t taken on any debt.

However, if all 10 of those people were to follow the very same advice and take on debt to purchase the same assets (the property you are buying hasn’t changed), then ALL of the asset prices reflect the extra debt now in the system. EVERYBODY will now have to take on debt in order to purchase the same asset.

Furthermore, once debt has been introduced into the system, it requires an ever-expanding amount of debt to keep prices rising.

Collectively, whilst we will have created a temporary illusion of increasing prosperity, we are all left poorer by allowing increasing debt to chase fixed assets.

At an individual level, sure it is a tempting short cut to prosperity, but like most shortcuts they are short sighted.

Using gearing to fund asset price speculation or investment is basically financial cheating.

If one athlete were to take performance-enhancing drugs, sure they could outcompete the other athletes, but if everyone followed this advice, there would be no competitive advantage achieved; all that would happen is that every single athlete’s health declines.

The same is true of our current position with house prices and debt. For too long, people have taken on ever increasing sums of debt in the foolish belief that it will make them wealthier.

But this is a fallacy.

All that has happened is that most of you, and especially your children, have become incredibly poorer.

We all now MUST take on excessive levels of debt to purchase exactly the same asset that people were previously able to purchase with far lower levels of debt.

We have not become wealthier by using debt to fund assets; we have become poorer.

Debt can be a useful for your finances and for building lasting prosperity, but not when used to increase the price of assets.

Debt doesn’t exist until it is created and therefore all that is achieved when debt is taken on, is that extra money comes into the system and we get asset price inflation, which has certainly benefitted the early few, but has left all of us collectively impoverished.

Viewing our prosperity as a whole, here are some situations when taking on debt could be viewed as being good (i.e. they could help improve our overall prosperity in a lasting and sustainable way).

Examples of Good Debt

Using debt to fund the purchase or development of productive assets.

If a company wishes to borrow money to build a factory or specialist tooling equipment that will improve their operations and productive capacity, then this debt is certainly good.

However, just because it’s generally considered to be a good debt, it doesn’t mean that it is always going to have a good outcome.

Too much credit funding even productive assets can cause problems because you can create the financial conditions for malinvestment and create overcapacity.

A very real and relevant example of this is China, who has built entire cities nobody lives in and presently have a huge steel overcapacity, both of which were fuelled by too much debt.

Using debt to alleviate a temporary cash flow shortage.

If you have sound household or business finances (i.e. you usually have continued income and your expenses are less than your outgoings), but you are facing a temporary cash shortage (a liquidity issue) then it makes sense to borrow money and stay afloat.

This is good for you personally and for society as a whole, because it is crazy to allow sustainable households and businesses to go under when after perhaps one or two years of financial struggle, they could return to health.

The challenge is to know when you are facing a liquidity crisis or an insolvency crisis.

Being insolvent means that you have no real hope of ever repaying your creditors, either now or in the future.

Taking on further debt to fix an insolvency crisis is simply delaying an inevitable bankruptcy and is therefore malinvestment of resources.

Using debt to fund education.

I believe that education is the single best investment you could ever make. No other form of investment will provide such life changing and lasting personal and financial gain.

There is a huge caveat to this however. It is only beneficial as long as you personally perform well, you get value for money from your education provider, and the subject of study will provide you with lasting earning capacity.

Too much university education nowadays fails the above criteria. Too many are coming out averagely educated, with little real job prospects and are just saddled with debt they could have avoided.

The education propaganda is that we all become wealthier by attending University, but the economic reality is that many of you will be poorer for the experience.

Is it really good debt?

There may be a few more examples of good debt, but what is clear is that taking on increasing levels of debt to fund a fixed asset, such as houses, has been beneficial for the early minority, but disastrous for all of us collectively.

The only result is asset price inflation and increasing levels of debt in the economy and financial system.

What have we really gained and how can this be described as good debt?

These are just some of the topics covered in my e-book Britain’s Debt Disaster.

By Mark Underdown

Financial Coach, Small Acorn Money

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