January 28, 2016

Debt: The Good, Bad and Ugly

Back when I first moved to California, I was a bit overwhelmed with the start up costs of creating a new life on a new coast. I was sure I was going to exhaust my savings and need to carry a balance on my credit card. Naive in the ways of finance, I believed that credit card balance was to be avoided at all cost. I had learned credit card debt is bad debt.

It wasn’t until a few years ago that I finally understood debt is not as clear cut as that. An acquaintance posed the question: is it better to drain the emergency savings account and pay of a credit card debt now, or keep the savings in tact and pay off the credit card debt over the course of a few months. The group consensus was to spend down the savings account. That didn’t sit right with me. Even with the large interest rate, the credit card would have only accumulated $30 of interest over those few months. Rather than thinking of the interest as wasted money, one could think it as the price of having that emergency fun. A pseudo insurance policy, if you will. Would it have been a good decision? Possibly. Being without an emergency fund carries it’s own risks.

It’s tempting to reduce complex concepts to simple sound bytes: Credit card debt bad, Mortgage debt good. But when we do, we tend to lose some of the nuances.

Good debt is debt on assets that appreciate, that add value above the cost of the debt. Bad debt is debt that doesn’t. Historically, mortgages have been considered good debt because homes tend to increase in value while student loans were considered good debts because education made you more employable, which lead to a higher salary. Recent history has shown us that neither is always the case. Revolving debt like credit card debt is usually considered bad because it tends to be spent on items that depreciate in value such as electronics or fashion. Even when credit cards are used to finance assets that appreciate, that appreciation is usually eaten up by the high interest rates.

It’s counter intuitive but a large interest rate on a small balance paid quickly still only generates little interest. My mistake when I first moved out to California was to not do the math, and see that for myself. I would have saved myself some unnecessary stress.

Each individual debt has a fixed cost. As a frugal penny pitcher, it’s tempting to avoid that cost at all costs. I need to train myself to compare costs, including opportunity costs. Sometimes, extra money is best spent elsewhere, like a high yielding savings account. The best way to make good decisions is to be informed. With that in mind I spent a little time the past couple of weeks working on some financial web apps. I can already see a little clearer.

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