Good Debt vs Bad Debt: How I Judge Borrowing
February 14, 2023
Good debt versus bad debt sounds like a simple distinction: borrow to buy assets, avoid borrowing for things that lose value. I think that’s a useful starting point, but it doesn’t go far enough. An investment can still go wrong, and the lender still expects repayment if it does.
In my February 2023 video, I said I had around £1.7 million of debt at that time. I wasn’t presenting myself as someone opposed to borrowing. I was explaining why the purpose, cost and risk of a loan matter much more than whether I can give it a reassuring label.
My central point was that the borrowing obligation is real, while the return you’re hoping to earn is uncertain. Before I call a debt useful, I want to understand both sides of that comparison.
You can watch my original discussion of good and bad debt alongside this article.
Start with what the borrowed money actually does
I draw a broad distinction between borrowing that may improve my future financial position and borrowing that mainly brings spending forward. A loan for a productive business asset is different from a loan for a holiday, even if the monthly payments happen to be similar.
That doesn’t mean the holiday has no value. People value experiences, celebrations and enjoyment for reasons that aren’t financial. My concern is the mismatch when the experience is over but the repayments continue for years.
Likewise, buying something described as an asset doesn’t make the borrowing sensible automatically. The price, running costs, expected income and financing terms still have to work. A poorly chosen investment can be more damaging than an affordable purchase made for pleasure.
I’d therefore ask what the loan is intended to achieve and how I’ll know whether that purpose has been met. A clear answer makes it harder to hide a weak decision behind the phrase “good debt”.
Why credit-card balances concern me
In the video I was particularly critical of expensive credit-card debt carried from month to month. Making the minimum payment can keep the account going without making the balance disappear at the pace someone expects.
I also explained that I used credit cards myself and paid them off in full each month. Those are different behaviours. Using a card as a payment method isn’t the same as relying on it as a continuing source of costly borrowing.
The interest rates I mentioned in 2023 were examples from that period, not current quotations. Anyone reviewing a balance needs the actual rate, fees, promotional terms and repayment requirements applying to their own account.
For me, the practical question is whether I can reliably clear the balance. If I keep telling myself I will do that next month and then don’t, the benefits associated with the card aren’t the main issue. The borrowing habit deserves attention first.
A business loan can have a productive purpose and still fail
I used a window-cleaning business as an illustration. Suppose the owner has more work than they can handle. Borrowing to buy another van and employ somebody might allow the business to serve more customers and earn more money.
That is a more productive purpose than borrowing simply to spend. But the extra income isn’t guaranteed. The employee may not work out, demand may fall, or operating costs may be higher than expected.
The loan payments don’t stop just because those assumptions prove wrong. That is the part I want people to take seriously before comparing the interest rate with the return they hope the expansion will produce.
I’d want to know how strong the demand evidence is, what the extra costs include and whether the business can cope if the expansion takes longer to pay for itself. Borrowing can help a sound business grow. It can also make a premature expansion harder to unwind.
More risk means more potential reward
One distinction I stressed was between “more risk, more reward” and “more risk, more potential reward”. The second version is much more accurate. Taking a risk doesn’t entitle me to a profitable outcome.
The FCA’s explanation of risk and returns makes the same broad point: higher prospective returns come with more uncertainty. I can’t remove that uncertainty simply by putting an average return beside a borrowing rate.
For example, borrowing at 5% to buy an investment that I hope will average 8% doesn’t create a guaranteed 3% profit. The investment could fall, deliver nothing for a period or produce returns at a time that doesn’t match the loan payments.
Those percentages are illustrations, not offers or forecasts. The question is what happens if the hoped-for return doesn’t arrive. If the only answer is “it should work eventually”, I haven’t properly dealt with the financing risk.
Why I often see mortgages differently
A mortgage is secured borrowing linked to a property. It can allow me to buy a substantial asset without paying the entire purchase price from my own cash, and that is an important part of how I invest.
However, the security protects the lender as well as shaping the borrowing terms. It doesn’t make the property risk-free for me. If the investment performs badly, I still have the debt and the consequences of failing to meet it.
A lender’s valuation also serves the lender’s purpose. I wouldn’t treat it as a complete condition survey or as confirmation that every aspect of the property is suitable for my plans. The buyer may need separate investigations and advice.
My buy-to-let mortgage guide explains why I look beyond the headline rate. Fees, rental cover, valuation, product conditions and the intended use of the building all affect whether the borrowing is workable.
An affordable mortgage can still restrict your choices
In the video I used an example of someone earning £8,000 a month and paying £5,000 towards a large mortgage. They may be able to make that payment, but it absorbs a substantial part of their income.
My point wasn’t that there’s a single correct mortgage payment for everybody. It was that affordability and opportunity cost are different questions. Money committed to housing can’t simultaneously be used for investing, building reserves or other priorities.
A home also has a personal purpose that a rental investment doesn’t. Space, location and family needs matter. I’d include those honestly rather than pretending the decision can be settled only by comparing investment returns.
Still, I think it’s useful to ask what the commitment prevents me from doing. A loan can be manageable on paper while leaving very little flexibility if circumstances change. That deserves consideration before stretching to the maximum a lender is willing to offer.
Look at the cash flow after all the costs
For a rental property, I want to know whether the income covers more than the mortgage interest. Repairs, management, insurance, compliance, empty periods and tax can all affect the amount left.
A property that rents for a good headline figure may still produce a thin surplus. If that surplus disappears with a modest rate increase or one repair, calling the mortgage “good debt” doesn’t fix the weakness.
My breakdown of buy-to-let profit from £1,000 rent shows why gross rent isn’t the same as spendable income. The calculation needs to reflect the way the property will actually operate.
I’d also distinguish repayment of capital from interest. Paying principal can build equity, but it still takes cash each month. An investment can be improving the balance sheet while putting pressure on the bank account, and I need to understand both effects.
Test the debt under less comfortable conditions
I don’t think there is one perfect calculation that captures every risk. There are too many unknowns. But that doesn’t mean I should ignore risk because it can’t be reduced to a single precise percentage.
I’d ask what happens if income falls, costs rise or the investment takes longer to work. On a property, that might mean a longer void, lower rent or a more expensive mortgage when the current deal ends.
I’d then look at what funds are available without relying on another uncertain transaction. If my answer depends entirely on refinancing another building or selling an investment at a convenient price, that dependency needs to be visible.
It’s also worth considering several problems arriving together. A reserve that covers one repair may not cover a repair, an empty period and higher finance costs at the same time. The exercise is about finding the weak points before the borrowing is committed.
The terms matter as well as the purpose
Two loans used for the same investment can create different risks. One may have a longer term, another a large payment due soon. One may have a fixed rate for a period, another may change with market conditions.
Fees, early-repayment terms, security and guarantees can also affect the decision. A cheap-looking rate isn’t enough if the overall arrangement creates a commitment the borrower doesn’t understand or cannot comfortably support.
My article on how property millionaires can go bankrupt looks at why assets and headline wealth don’t remove the consequences of debt and guarantees. The structure of the borrowing can matter as much as the value of what someone owns.
I’d want the relevant professional to explain those obligations before I agree to them. Understanding the downside isn’t being negative about investing. It’s part of deciding whether the opportunity is worth taking.
Judge debt by the whole decision
I’m comfortable using borrowing when it supports a considered investment plan. I’m much less comfortable with the idea that borrowing becomes sensible merely because the money is going into something called an asset.
For me, the useful questions are what the money is for, what the debt really costs, how uncertain the return is and how the payments will be met if the plan disappoints. Those questions are more valuable than a simple good-or-bad label.
If you’d like to discuss how borrowing fits your property strategy, book a free 30-minute call. You can also explore the Starter Club or find out about Done For You for support with your next step.