Having debt isn’t always such a bad thing. If you could pay cash for your college education, a house, and a car, you probably would. Unfortunately, most of us simply can’t afford to do that. If we want these things we’ll need to borrow money, which means debt. But having debt doesn’t mean that you’re financially irresponsible. In fact, in some situations, it actually may make more financial sense to borrow than to pay cash.
What is Good debt?
It’s tough to think of having debt and paying interest as a “good” thing when considering personal finances, but there’s times when it actually makes perfect sense to borrow money to be paid off over a long period of time. There are a three major factors involved in determining if something is “good” debt.
- Monthly payments – Most experts recommend keeping total long term debt payments under 40% of of your gross monthly income.
- Interest rates – Look at the effective rates (after tax deductions) and if you can keep the rate under 5% you’re in good shape, but the lower the better. Protip: If you can get a higher return by investing than you are paying in interest, it’s better to invest the capital and keep the debt than to pay cash for your purchase.
- Rate of return – Think of your purchase as an investment. Consider the potential return and/or value after the loan has been paid for. Keep this in mind when comparing your loans to the ROI from investments.
Because your level of education is a major factor in your income level, you can look at it like an investment. In 2008, the median annual salary for a male with a high school degree was $43,165, compared to those with a Bachelor’s degree who earned $82,197. A difference of nearly $40,000 which would pay for a $200,000 degree in about 5 years. So getting a 4-year degree is a pretty good investment.
But just because an education is a good investment doesn’t necessarily mean taking a loan out a good idea. Interest rates must be taken into account. Public education loans have markedly low interest rates and because the interest is tax deductible, the effective rate is even lower. Private loans tend to be more expensive and less forgiving about repayment right after school.
Other factors, like potential job prospects, salary (particularly starting salary) and stability may also be taken into account to determine how much you can afford to borrow. The bottom line is: student loan debt is one of the most forgiving types of debt a person can have.
Home purchase/Real estate
Purchasing a home can be a good investment. Real estate tends to appreciate in value over time and you have the advantage of building equity compared to renting/leasing an apartment. Home loans also tend to have relatively low interest rates, especially for first time home buyers. Programs like FHA make it even easier to handle mortgage debt.
Home equity loans and other real estate purchases also may fall under “good” debt. If you take a home equity loan out to make improvements to your home that increases the value of the home you can get an instant ROI, so it could make sense to borrow the money. Mortgages on vacation homes and second homes can even be considered “good” debt so long as the home retains/appreciates its value and total debt payments don’t exceed 40% of your monthly income.
Car and other low interest purchases
Car loans and other mid-to-long-term low interest rate purchases can also fall into the “good” debt category, though they’re not usually quite as good as the above two examples. Some car loans for purchasers with a good credit score can be on the very low side, making investing a better use of your cash than paying for a car outright. Also, unless the car is a classic, it probably won’t appreciate in value, but that doesn’t mean that it has none. Average resale value can be a big factor in whether taking a loan to buy a car is good or bad debt.
What is Bad debt?
Bad debt is essentially any long-term debt for items that have little to no value and/or carry higher interest rates. Also, if debt payments start to exceed 40% of your gross income, it may become more difficult to get out of leaving you with a life-time of debt.
Bad debt isn’t always avoidable and doesn’t make you a bad person. There are times when you may need to borrow money for a purchase that doesn’t fall into the “good” debt category and that’s OK. As long as you make paying down this kind of debt a high priority.
Credit card debt is the most common and glaringly obvious example of bad debt. They tend to have high (and in some cases EXTREMEY high) interest rates and penalties. In many cases, paying the minimum monthly balance will lead to paying more in interest than the original purchase price! Credit card debt is a dangerous and common personal finance pitfall. Use them wisely.
Like credit cards, retail financing options for medium-large purchases tend to have high interest rates. Something they also have in common are low introductory rates to draw you in. In many cases people believe they are getting into a good debt situation when in fact the interest rates aren’t much better than their credit card.
You may want to take that dream vacation this year, but if you can’t afford it, keep saving until you can. This and other excess and/or recreational purchases will almost always fall into the bad debt category. These items tend to have less long-term value and can quickly become a large part of your monthly bills for things that you don’t need. Also, it’s rare to get financing at interest rates that could be considered good.
A simple test:
1. Is this something that you need?
- NO – don’t finance it.
- YES – Continue to question 2
2. Is the purchase an investment with potential financial returns or sustainable equity?
- YES – Finance it
- NO – Continue to question 3
3. Is the effective interest rate lower than your average investment return?
- YES – Finance it
- NO – Consider paying cash