Good vs Bad Debt: Does Good Debt Exist?

Written by: Samantha Masey – Associate Wealth Advisor

I recently had a conversation with someone who shared that his parents taught him that all debt is bad, and it has significantly influenced his financial decisions. Since becoming a financial planner I hear this sentiment more and more from clients, friends, and family. Many people believe they need to minimize their debt and be completely debt-free at retirement. However, in today’s environment, this simply isn’t the case. In this article, we will discuss why not all debt is bad debt.

Key Takeaways

• Good and bad debt defined
• Mindset readjustment in a low interest rate environment
• A simple calculation to help manage your debt

GOOD VS BAD DEBT

Good Debt

So, what is good debt? CNBC defines it as money owed for things that can help build net worth or increase income over time. You can think of good debt as investing in yourself or your essential needs such as a place to live. The idea is that the money that flows into these debts will produce returns as if it was a portfolio investment. Good debt usually has low interest rates. Examples include mortgages, student or business loans, and consolidating debt.

Historically, mortgages are considered safe debt because your monthly payments will eventually build equity in your home. The caveat to remember is that good debt will become bad when too much strain is put on your budget. A general recommendation is that you should not spend more than 28% of your monthly gross income on a mortgage payment.

Student loans are considered investing in future potential earnings. Not all degrees are created equal and thus future earnings can vary. When making student loan decisions you want to weigh how much debt you should take versus how much you will earn. A good rule of thumb is that you shouldn’t borrow more than your expected first year’s salary.

 

Bad Debt

Bad debt is easier to identify. This form of debt loses value the moment you take ownership. It puts you in stressed financial situations and usually has high or variable interest rates. The most common forms are credit card debt, personal and auto loans.

Credit cards are a pitfall for many people. It can be easy to accumulate large amounts of debt at high interest rates. The promise of a small monthly payment can cause people to owe money for long amounts of time and the debt to spiral out of control. Personal loans can be a good idea if you have a specific goal in mind but using them for material possessions or vacations can be a costly habit. Auto loans are considered bad debt because cars lose value the second they are driven off the lot and continue to depreciate over time. However, owning a car is a necessity so my recommendation is to purchase a car that meets your personal and financial needs. Avoid splurging on an unnecessary sports car. Additionally, the interest rate of your auto loan is important. Right now is a great time to purchase a car because rates are so low. It could also be time to think about refinancing your bad debts.

 

MINDSET READJUSTMENT IN A LOW INTEREST RATE ENVIRONMENT

In a normal interest rate environment paying off debt even good debt makes sense, but we are currently in a period of historically low interest rates. In the exhibit below, you can see the 10 Year Treasury Rate since 1962. I have circled where we are today in red and the previous lowest rate in blue. We haven’t seen interest rates this low in 60 years.

This changes the strategy on how you want to pay off good debt. What we are seeing today is a shift towards the understanding that certain forms of debt can be beneficial or present opportunities for greater net worth in the long term. As with most things, too much debt isn’t a good thing. However, a manageable amount of debt at low interest rates can actually provide a benefit to you.

A few pros of debt to consider are:

• The ability to invest excess funds that would have otherwise gone to paying off debts.
• Saving money by refinancing while interest rates are low.
• Increasing your credit score through consistent debt payments.

I personally refinanced our student loans this year. Without taking on additional debt, my husband and I lowered our interest rate by 2%, extended by 5 years and decreased our monthly payment. When it is all said and done, we will actually pay less than if we had stuck to our plan of finishing to pay it off in 2 years. This has allowed us the opportunity to put extra dollars towards our retirement savings that would have otherwise been used to pay off debt.

This strategy also applies to how you handle mortgage debt. Instead of buying your dream home in cash, consider partially financing and investing that cash while mortgage rates are still low. Let’s say you finance a 30-year loan at 2.5% and your portfolio investments are growing at a rate of 6.0%. You could choose to pay down your mortgage quicker with your extra cash flow. However, the opportunity cost would be sacrificing the growth of investing your cash in your portfolio. This way of thinking is currently beneficial because interest rates are so low.

 

SIMPLE DEBT CALCULATION

A simple calculation to better understand your personal finances is the Debt-to-Income (DTI) ratio. This ratio compares how much you owe to how much you earn on a monthly basis. When calculating, use your gross income which is income before taxes. In general, a good benchmark is 36% or lower. A lower ratio indicates that you manage your debt payments effectively and have sufficient income. It can also reveal that you can afford to take on more debt up to a certain point. A higher than 36% ratio indicates that you are overextended or have too much debt. Even with good debt, you can have too much debt.

 

CONCLUSION

The key takeaway is that good debt helps you achieve your goals and bad debt can derail them. Good debt can become bad when you have put too much strain on your cash flow. Use the Debt-to-Income calculation provided in this article to help you understand what your budget can sustain. The old adage you need to spend money to make money comes into play when we are talking about good debt. Spending money on your education, business or real estate can be avenues to generate greater income in the future. On the flip side, debt to pay for consumption habits can lead to major strain on your budget and no future returns on your investment. Ask yourself, will my returns be greater than my investment?

If you have any questions regarding debt management, please feel free to contact our team for a discussion. Take today’s article one step further and create a personal budget. The following recommended reading walks through how to create a budget and put yourself on a path to financial wellness.

Recommended Article: The Importance of Budgeting

 

Bouchey Financial Group is a fee-only, fiduciary, financial advisory firm with locations in Saratoga Springs & Troy, NY.