Which Debt Is ‘Good Debt’ and Which Is ‘Bad Debt’?

Let’s talk about debt baby. Let’s talk about you and me. Let’s talk about all the good things and the bad things that may be. Let’s talk about debt.

Do I have you humming the tune to a popular Salt-N-Pepa song circa 1990?

I have to bring some joy during the pandemic! OK. We talked about the importance of budgeting and cash flow analysis. Now, let’s focus on a related topic: debt.

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True or false? Some debt can be good. Answer: True. But there’s a catch. You should be responsible with debt and use it to acquire an appreciating asset; in other words, an asset that will increase in value over time. This takes discipline and focus.

Good Debt: Mortgages and Student Loans

Most people can’t afford to purchase a home outright, or entirely with cash. They rely on a mortgage to finance the home purchase. If you are a first-time homebuyer, I’d strongly urge you to save at least 20% of the home’s purchase price for a down payment. Otherwise, you may have to take out a secondary loan at a higher interest rate or pay private mortgage insurance, also known as PMI. What if the value of the value of your home declines after the initial purchase, as happened to me in 2005 near the peak of the real estate market? I wasn’t a financial adviser then and had only saved 10% for the down payment. My first home was a big financial mistake — at least a $15,000 loss on a $150,000 starter home when you factor in closing costs, realtor commissions and renovations. Yet, I learned valuable lessons.

Mortgage debt can be good. In fact, my husband and I recently had the option of taking our Missouri home sale proceeds and providing even more than a 20% down payment on our new home in Florida. However, with the mortgage rates so compelling, we kept the extra cash and invested it in other long-term goals. You can exercise the same judgment when purchasing a new home.

The other “good debt” could be student loans. In many cases, bachelor’s degrees are required to get into any white-collar position. Some professions demand additional schooling. A newly minted doctor or lawyer could easily have over $200,000 in student loan debt.

Is your child entering college soon? If so, have a candid conversation with him or her about constructing a plan to pay off the debt. Think about the chosen career field, average annual earnings, and time it takes to secure a position. Make sure that the student loans you’re taking out make sense in that context, or else that good debt could turn into bad debt pretty fast.

Is your child entering a field where supply outweighs demand? Some advanced degrees no longer carry as much weight. I know a handful of law school graduates who could not find reasonable employment within a year of graduation, let alone a six-figure salary with a top-tier firm.

Not-So-Good Debt: Credit Cards and Autos

Debt isn’t always good. It can be crippling to people who don’t responsibly manage their finances. Credit card companies prey on individuals who make the minimum payment. This may sound harsh, but only buy on credit if you can pay off the balance in full each month. If you spend more than you earn and need help with cash flow management, refer to my related articles on the envelope and detailed budgets.

Credit cards aren’t the only type of debt. Payday loans are even worse. They provide quick cash but charge an exorbitant interest rate. Tax debt is also dangerous. As the Federal Trade Commission points out, tax relief companies collect thousands of dollars up-front and promise to settle your tax debt, but few actually deliver on that promise.

On a related note, have you seen the prices of cars and trucks these days? The average sales price for light vehicles in July was $38,378, according to Kelley Blue Book. If you are overly concerned with what friends and neighbors are driving, you may be tempted to buy a new car every few years. This is a dangerous proposition. The desire to “keep up with the Joneses” really impacts your ability to build long-term wealth. When does it stop? After you have a luxury car? Two of them?

A car depreciates quickly. If you purchase it for $40,000, it may only be worth $30,000 a year later. Not only are you making monthly payments, but you’re also going to get far less money when you sell it. Additionally, there is no tax deduction for personal vehicle financing (business purchases are a different story).

The solution? Hold on to a new car at least seven years. Save up for the next car when you don’t have any more payments on your current vehicle. Or, get ahead of it and buy a used car with more mileage. You may not be able to keep it as long, but you most likely can negotiate a lower price.

When you feel burdened by debt, there are steps you can take to clear negative items from your credit report. Kiplinger.com provides an excellent, in-depth guide on the factors that influence your credit score and steps you can take to boost it.

Pay Down Debt or Save?

All right. You see how some debt is healthy. How do you know when to pay down debt rather than use that money to save more for retirement? Here are a few considerations:

1. Build an Emergency Fund

Set aside enough cash in a money market account for true emergencies. If “emergency” evokes too many negative emotions, reframe it as an opportunity fund instead. This may be an opportunity to start a side business, travel more or accomplish another goal.

2. Get the Employer Match

Ensure you’re contributing enough to your employer’s retirement plan to take full advantage of the match. It’s a no-brainer. Unfortunately, several employers have reduced or taken away the company match in 2020 because of the pandemic. If your family is still in a strong enough financial position to contribute to your 401(k) plan at work, consider maintaining your normal retirement contribution. This means you do not have to remember to reinstate it when your employer resumes the 401(k) match.

3. Weigh the Investment Rate of Return vs. Debt Interest Rate

This assumes you’ve already built an emergency fund and are taking advantage of your employer’s match. Let’s say you have a credit card balance of $10,000 on which you pay nondeductible interest of 15%. By getting rid of those interest payments, you’re effectively getting a 15% return on your money! Which sounds better … paying off this credit card or earning 7% in an investment account? In this case, eliminating high-interest debt should be a bigger priority.

4. Consider a Hybrid Approach

If you’re an intensely focused person who values logic over emotion, making the best financial decision gives you satisfaction. Emotion may not come into the equation. You focus all energy on paying down “bad” debt.

For others, financial and emotional decisions function differently. What makes the most financial sense may not “feel” good. You have many intentions — paying down student loan debt, saving for retirement, and funding your child’s education. Putting all financial resources toward a single goal may not make sense to you, emotionally. Instead, allocate a small amount of money toward each goal.

Some clients who have mastered their day-to-day finances ask me, “Should I prepay my mortgage?” It’s a good question, and I don’t always have a definitive answer. First, we focus on financial specifics like the mortgage interest rate, loan term and income tax bracket. I also consider the client’s timeline for investing and risk tolerance. Thus, it’s easy to tell them which decision is better financially.

Yet, we can’t ignore the emotional aspect. Why does the client want to prepay the mortgage? Is it to fulfill a lifelong dream to be debt-free by age 50? Travel the world five years from now? What is the underlying ambition?

The bottom line is this: Debt, when used properly, can be a great tool to achieve your financial goals.

Debt is just one of the many concepts we discuss at Redefining Family Wealth. Get our FREE wealth-building tips and Starter Guide when you join the Redefining Family Wealth email list.