Good Debt vs. Bad Debt

Good Debt vs. Bad Debt

By: Vanessa McElwrath, CFP®, Wealth Management Partner

 

My husband and I recently celebrated our 7th wedding anniversary. As is our custom tradition, we revisited old wedding photos and reflected on that time and how much our lives have changed since then. For us, 2012 was a pretty momentous year for us personally and financially. In the months leading up to our wedding date, we closed on our first house. As daunting as it was to sign on the dotted line of our home loan, it felt like we were making an investment in our future as “The McElwraths.”  This was a moment in which it really hit home that debt can be complicated- its’ not all bad.  Certain types of debt, such as a mortgage, can actually provide opportunities to improve your financial future.

Since 2012, I’ve had the opportunity to have many conversations with clients, 401k plan participants, family, friends and colleagues about debt- the good, the bad, and the ugly. It’s important to be able to understand the differences in order to make smart decisions about if, when, and how much to borrow.

It’s not all bad

In general, good debt is often an investment in your future or something that will provide value to you down the road, such as a home or student loan.  Ideally, it should be at a reasonable interest rate and have potential tax advantages.

  • With mortgages, you’re borrowing to own a potentially appreciating asset, and it may be tax-deductible. For example, if you file jointly with your spouse, you can deduct the interest on mortgage debt of up to $750,000 on your primary and/or secondary residence.
  • With student loans, rates are comparatively low, and interest can be tax-deductible, depending on your income. Benefits include enhanced career opportunities, which will increase your earning potential in the long run. Still, it’s a good idea to conduct a cost benefit analysis by taking into consideration the desired degree/major, public or private university, and income earnings potential post college.

It’s important to note that “good debt” must be considered carefully and in context. If the 2008-2009 Financial Crisis taught us anything, it’s that too much “good debt” such as home debt and student loans can still be ruinous to your finances. Make sure you are not over-extending yourself. As a general rule of thumb, house debt payment should not exceed 28% of your pre-tax income, and all debt payments should not exceed 36% of your pre-tax income.

Debt that can work against you

If you find that you’re using credit to provide instant gratification and to purchase items that offer little or no long-term value or financial return, consider it a red flag. Generally speaking, you should avoid debt that is high cost and isn’t tax-deductible, such as credit cards and some auto loans.

  • Credit cards are usually necessary and are helpful as long as you pay them off every month and aren’t accruing interest. If you keep a balance, the high interest rates will prove to be very costly over time.
  • If you purchase a new car, you’re borrowing on something that immediately loses value as soon as you drive it off the lot. A used car is usually more cost effective, but still loses value over time. Do your research to make sure you’re getting the best APR (annual percentage rate) possible and choose a vehicle you can truly afford.

Save for retirement or pay down student loans?

Millennials often struggle with the choice of saving for retirement or paying off student loans. It doesn’t necessarily need to be one or the other. Outline a plan to make it manageable:

  • First make the minimum loan payments.
  • Next, if there’s money left over, take advantage of your company’s 401k match.
  • No workplace retirement plan? Consider opening up a Roth or traditional IRA account.
  • Put any additional funds against your highest-interest-rate loan.

Set up an emergency plan

To avoid having to tap into debt during a jam, make sure you have a safety net. It’s wise to maintain a liquid emergency reserve of at least 3-6 months’ worth of expenses so that you don’t have turn to credit when the unexpected occurs.

Related posts