Is Debt Necessary For Generating Income?

“Margie” writes in:

My husband and I are pretty frugal, but we currently carry about $25,000 in credit card debt and a personal loan. Our monthly interest is about $800 on the balances.

My husband owns his own business and has cash in hand to pay off these balances; however, he chooses to keep the money in the business because the $25,000 cash generates about $5,000 income every month– enough to pay the interest and pay about $1,200 on each one of the the personal loan and two credit cards. This way we’ll be able to pay off the balances in about six months.

I used to feel very scared about carrying so much debt, but when he explained it to me I understood that sometimes debt is necessary in order to keep generating an income (his degree is in business economics). If we were to pay off the $25,000 it would take capital out of the business and we would lose a big chunk of income-generating money. This way we’ll be debt free soon and still have the $25,000 in the business.

What are your thoughts in this scenario?

First of all, it’s worthwhile to get a bead on how bad this debt actually is. Margie reports that she and her husband are carrying about $25,000 in debt, with a monthly interest total of about $800 on that debt. That didn’t pass the smell test to me – $800 a month in interest comes out to $9,600 a year, accounting for almost a 40% interest rate.

No matter what the reason, if you hold debts that have an interest rate that’s in double digits, you should seek to lower that interest rate. There are almost always debt solutions that allow you to reduce your interest payments if you’re carrying debt at such a high level.

So, the first step is, as always, make sure that the debt instruments you’re using are good ones. If you have debt that’s being charged at a high rate, see if you can move that debt into a different loan that doesn’t have such a high rate or request a reduction in rates.

Now, on to the meat of the question. Is debt acceptable if the balance of that debt is used to generate income?

If you’re looking at a guaranteed income, then the question is really whether the interest on the debt is lower than the income generated by the money. So, if you had a completely guaranteed method to return 10% on your money and you could borrow money at 5%, then this is a very sensible deal.

The problem is that there are no guarantees in life or in investments. Virtually every time you borrow money, you’re adding to your risk.

Sometimes that risk is worthwhile. If you need a car to get back and forth to work and you have no car, then a car loan is probably worth it. If you need an education to further your personal goals, then a student loan may be worth it.

The general question that’s really being asked here is whether a business loan is worth the risk. Certainly, a well-planned business (that’s structured independently of your personal finances, of course) may need to borrow money in order to get the business started.

However, the situation as Margie describes it appears to be a loan to the business out of their personal finances. While that can be fine, the loan is clearly having a very painful effect on their personal financial situation.

No matter how secure the business, funding that business via a high interest personal debt is not a good way to go. The risk simply isn’t worth it – if the business does not succeed, you will quite likely be left in a very sticky situation.

My advice to Margie and her husband is simple: put a lot of effort into restructuring your personal debt. See if you can reduce the interest rate on that debt and get it down to something manageable. Otherwise, you’re putting your personal finances at a very steep risk in order to sustain your business – which is never a guaranteed proposition.

If you’re just getting started and looking to start a business, never fund it via your personal finances if you have to take out high-interest personal debt to do it. That’s an extremely dangerous situation to put yourself in. Instead, seek business financing or wait until you can fund the business in a safe manner.