Word of The Day – Good Debt

Good Debt – Debt that it pays to keep

Definition – debt based on income-producing assets

Discussion – There are actually two steps to amassing good debt. The first component of good debt is that the liability incurred is based on an income-producing asset. This income can be earned income (i.e., the asset being your labor), or it can be passive income or portfolio income (i.e., the asset being your investments). These different ways of “making a living,” although taxed at different rates, are all based on owning an asset or assets that provide income to pay debts.

The second component of good debt is satisfied when one has a residual income or cashflow greater than the sum of one’s total periodic liabilities, (e.g., one’s monthly bills). In other words, one’s debt payment is sustainable over time. There is enough income left after the bills are paid to pay for the interest owed on the debt. Also, you own an asset or assets that, if necessary, can pay off the entire debt by some point in time.

For example, If employed — you know you have paycheck, although a layoff, injury, or loss of benefits could change things. If self-employed – you know you have a business plan even though things may not go according to plan. If an investor, you know you have investments, although the market price could drop, or those investments could go bad. The only difference is that employed and self-employed individuals are severely limited by the value of their asset (the income earned) and its duration. That’s why employed and self-employed people also need investments to live independently upon retirement.

Accumulating good debt is usually a two-step process: (1) development, followed by (2) success in accumulating assets. This is how individuals, households, businesses and governments can sleep well at night while still owing debt.

Here’s an example of good sovereign debt. A country borrows from other countries at an interest rate of X%. The country uses that money to develop an export industry using its natural resources and labor. During the development phase, the country has a potential for good debt because it is building an asset for itself. If it succeeds, then the the exports created enable it to pay the X% interest each year and have another 2-5% “residual income, i.e., cash-flow left over, after expenses. The country will still be in debt for the loan, but it now has the means to pay the interest for each period over time. And it now owns a new income-producing asset.

Individuals, families, businesses, and nations all need to acquire good debt to survive and live well over the long term. In regard to debt, including sovereign debt, the question isn’t just the amount of debt involved, but rather how will that debt be able to be sustained! What assets does a a individual, a group, or a nation have that will enable it to meet its periodic expenses over the long term.

Related terms:  Capital; Assets; Liabilities

Copyright © 2011 Nancy K. Humphreys