Tuesday, May 11, 2010

Good debt, bad debt, Tax Deductable debt. The Cost of Capital.

A lot of articles try to classify debt as good and bad,
If you borrow to invest it is good debt,
If you borrow to spend it is bad debt.
If you can tax deduct it, it is good debt.
If you can't tax deduct it, it is bad debt.

But I am posting this to say that the way i see it money is money the source and purpose are irrelevant. and the only number that matters is the cost of capital.
Finance the deal at hand with the cheapest source of funds.
The source is irrelevant, it could be cash or it could be a loan. The item being purchased is irrelevant, it could be a consumer item or an investment.

If you are at Home Depot and you are buying some construction materials, The brick buying a big screen TV or sears buying whatever it is people buy from sears. It does not matter what you are buying, it could be for consumption, it could be a vacation or it could be for investment. regardless of what you are purchasing you must use the cheapest source of funds to finance the purchase. In this case it will be the 0% don't pay for a year retail credit card these places offer.

If you are buying a car and the dealer is offering 0% financing, you take it.

Using your own cash for these situation will cost you the opportunity cost of that cash which is more than 0%.

Normalize Interest on debt then prioritize for borrowing / repayment according to cost.

Say you borrowed some money from your line of credit to invest. now the line of credit is a tax deductible 6% loan. good for you.  now say your in the 35% tax bracket that would be equivalent 4.45% non deductible loan.  so even though this loan is tax deductible you should still pay it off before any non deductible loan costing less than 4.45% regardless of which loan was used for what purpose.

I see capital as a stack of cards, where the cheapest sources are at the top, you use the cheapest sources first. and as you deploy more capital, you deplete the cheapest sources and so the cost of new capital gradually rises, until you reach a point where it is not worth the risk to deploy the more expensive capital.

Need money for an investment or consumption, take the top card on the stack, which is the cheapest way to pay for it.

Got some new source of funds, add it into the stack at the appropriate spot according to its cost.

Then optimize the stack as needed, moving funds from cheaper sources to pay off more expensive sources.

Good debt or bad debt is meaningless, only the cost of capital matters.


  1. Maybe the only way to correctly judge a debt as good or bad is in specific, and relative terms, eg: A credit card at 18% interest is less desirable than the same credit card at 7%. I like the addition of the $100,000 target bar. You are aiming for a total dividend accumulation of $100,000? That would be very impressive. I will follow your blog until you reach your goal.

  2. Exactly all that matters is the cost. 18% costs more than 7% it does not matter what the purpose or source of the loan is.

    yes 100,000$ yearly dividends is my target. take a big bite then chew like hell approach.

  3. Interesting post- love the semi-poem!

    Wow $100K a year on dividends- love it.
    let's hope Canada doesn't change the taxation rules on dividends any time soon!