Good Debt vs. Bad Debt: A Wellness Screening
Is all debt bad?
It's the ultimate paradox, isn't it? Debt can be a key component of your investing plan, but it can also limit your ability to invest. It can prevent you from making progress toward your goals, but it can also help move you in the right direction toward them. Sometimes, it feels like an anchor around your neck; other times, it lets you breathe a sigh of relief.
You'll often hear financial pros talk in terms of "good debt versus bad debt," with "good" debt describing things that aim to build your net worth or help you increase your lifetime earnings, such as a home mortgage, business loan, or student loan.
"Bad" debt would be borrowing that goes toward a depreciating asset, such as a luxury item, or any debt that carries a high interest rate, such as a payday loan or a high-interest credit card.
But framing debt in terms of good versus bad might not tell the whole story. Another way to look at it would be useful versus costly debt, or better yet, healthy versus unhealthy debt. Refer to the table for some of the classic categories of debt.
- Healthy debt: Aims to increase your long-term net worth
- Unhealthy debt: Predatory loans and debt to finance depreciating assets
Healthy debt: Aims to increase your long-term net worthMortgage>Unhealthy debt: Predatory loans and debt to finance depreciating assetsCredit cards and other revolving debt>
Healthy debt: Aims to increase your long-term net worthStudent loans>Unhealthy debt: Predatory loans and debt to finance depreciating assetsLoans for vehicles or boats>
Healthy debt: Aims to increase your long-term net worthLoans for technical trading, certifications, job skills>Unhealthy debt: Predatory loans and debt to finance depreciating assetsLuxury goods (hot tubs, designer clothes, jewelry, etc.)>
Healthy debt: Aims to increase your long-term net worthBusiness loans>Unhealthy debt: Predatory loans and debt to finance depreciating assetsPayday loans, title loans, and other high-interest debt>
Do you have healthy debt?
Doctors and nutritionists like to frame food choices in terms of good versus bad. There's good and bad cholesterol, good and bad carbs, and even good and bad types of fats. But when consumed in excess, even the good stuff can negatively affect your health.
Yes, there can be too much of a good thing.
In economics, we call it diminishing marginal utility: For each additional unit added, the extra benefit is less and less until you reach the unit that actually does more harm than good.
What is good debt?
Case in point: your mortgage. Borrowing to finance a home can be a good thing because home prices have historically appreciated over time. Sure, you pay interest on a home mortgage, but the interest is usually tax deductible, which means you save on your tax bill from Uncle Sam.
Plus, assuming it's your primary residence, you save the opportunity cost of renting a home or apartment. However, buying more house than you can afford can make you cash-poor and thus vulnerable to a cash squeeze that might force you to max out a credit card or take out a payday loan.
A student loan is another classic example of healthy debt that can become bad for one's financial health above a certain level. Sure, it's an investment in your education and therefore the potential for higher lifetime earnings.
But a number of studies point to student debt as a major reason millennials may delay buying a home, saving for retirement, or working toward other long-term financial goals. Prior to the COVID-19 pandemic, the average student loan payment was nearly $400 per month, according to Federal Reserve data. That can certainly leave a dent in one's savings plan.
What is bad debt?
On the other side of the ledger is bad debt. And bad debt is pretty much always unhealthy. Payday loans, title loans, and other so-called predatory loans can put borrowers in a debt trap from which it's nearly impossible to escape. Even the ubiquitous credit card has been known to put folks quickly over their heads if the balance isn't paid off in a timely manner. Interest rates on credit cards are typically much higher than other forms of debt and can add up quickly.
But what about auto loans? Loans on depreciating assets, such as cars and boats, are usually categorized as bad debt, but really, auto loans can be argued either way. On one hand, reliable transportation can be important for your job security and advancement. On the other hand, a car tends to drop in value the minute you drive it off the lot. For auto loans, and for any loan really, it's important to negotiate the lowest interest rate for the shortest borrowing time.
And again, if you buy more than you need, the debt shifts from healthy to unhealthy. There are work trucks, family haulers, and point-A-to-point-B cars. And then there are luxury SUVs and exotic sports cars.
With your money as well as your health, moderation is key.
How to maintain healthy debt
So how do you make sure your good debt doesn't reach artery-clogging levels?
Step one is to create a debt strategy. Some financial consultants might suggest organizing your strategy as a set of rules and hierarchies, i.e., "do this, not that," and "do this before that."
Here's a sample:
- Know your limits. Don't take on more obligations than you're comfortable with. Think about whether you or your spouse/partner would be able to pay for those obligations if either of you were to get sick or injured, lost your job, or passed away.
- Make it part of the plan. It's typically good advice to include debt management in your financial planning. And be sure to plan for the unexpected.
- Keep the good debt good. If you're preparing for retirement, it's a good time to check your balance sheet and start making some adjustments. You could argue that maintaining some good debt can help you build wealth for retirement. And it's OK to use credit cards, as long as you're diligent about paying them off. Using credit responsibly and establishing a track record of repayment can actually help raise your credit score.
- Seek to minimize the effective cost of debt. One piece of advice you might hear often is to focus on paying off the debt with the highest interest rate first, then turn your attention to the debt that has a lower interest rate. Plus, some households are better served by keeping low-interest debt, receiving the tax benefits, and investing the excess cash flow to pursue a higher long-term rate of return. It's like leveraging your wealth to try to build more over time.
- Get help. You may also choose to seek help from a financial consultant. One thing an advisor can do is help you stay on track. Periodic reviews of your financial situation also open the door to make necessary changes along the way that should help you pursue your goals.
Working with a financial pro can help you map out the best long-term plan for your individual situation, from your first investment foray to retirement and beyond. For example, when you're starting out, you might need assistance setting up an investment plan while also saving for the future. If you're nearing retirement and have debt, consider reviewing your debt strategy with a financial advisor and developing a financial plan for paying off major items like new cars or home renovations once you've retired.
Sometimes debt can be a useful strategy, even in retirement. For example, a financial professional might be able to help you decide if you should spread payments out rather than taking a large lump sum out of your investment or retirement accounts.
Good debt vs. bad debt: What's the difference?
Debt doesn't have to be bad for your financial health if it's used wisely as part of an overall wealth-building plan. But it pays to understand the difference between the healthy kind and the unhealthy kind. And as with your diet, remember to exercise portion control, even with the so-called healthy stuff.
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