Good Debt vs. Bad Debt

The one thing that keeps most Americans up at night is not a lumpy mattress or getting chased by a naked Woody Harrelson in a dream.

It’s the Big D – Debt.

And more than a year of living with COVID-19 hasn’t helped. Some 64% of Americans cite money as a significant source of stress, according to the American Psychological Association; 52% blame the pandemic for worsening their financial situation.

There’s even a term for it: debt stress syndrome.

Americans are awash in red ink. The Federal Reserve Bank of New York reported U.S. household debt surpassed $14.56 trillion in the fourth quarter of 2020, a $414 billion surge from the same period in 2019.

Credit-monitoring giant Experian put the average U.S. household debt at the end of 2020 at $92,727, a 10-year high.

So we’re in trouble, right? After all, Big D is sinister, a stress-inducing, panic-wreaking phenomena that can be a waking nightmare.

But wait. Tucked away in the Experian study is a slender cause for relief: Just as we’ve been taking on more debt, we’ve driven down credit card balances by 14% — Experian calls that “historic” — and we’ve trimmed home-equity line-of-credit debt, too.

The debt we’ve added? Home mortgages, student loans, and automobile loans. Which makes this as good a place as any to mention today’s theme: Not all debt is created equal. Some deserves all the worry it induces. Others should let you dream of a more financially secure future.

What’s the Difference?

A simple rule about debt is that if it increases your net worth or has future value, it’s good debt.

If it doesn’t do that and you don’t have cash to pay for it, it’s bad debt.

The next question is how do you know you have too much debt?

There are general clues, like if your main source of income is selling your blood plasma. A more accepted metric is your debt-to-income ratio.

Add all your monthly debt payments and divide them by your monthly gross income (not just your take-home pay) to get your debt-to-income ratio. For instance, if you have a $1,500 monthly mortgage, $200 car payment and pay $300 a month for credit cards and other bills, your monthly debt is $2,000.

If your gross monthly income is $4,000, it means your debt-to-income ratio is 50%.

It also means you deserve your sleepless nights.

Anything over a 43% debt-to-income ratio is a red flag to potential lenders. Evidence suggests that borrowers with a higher ratio are more likely to have problems making monthly payments. In most cases, you can’t get a mortgage if your ratio is above 43%.

That’s bad, because guess what is probably the best form of debt? Mortgages!

What’s Considered Good Debt?

Good debt allows you to manage your finances more effectively, to leverage your wealth, to buy things you need and to handle  unforeseen emergencies.

Examples of good debt are  taking out a mortgage, buying things that save you time and money, buying essential items, investing in yourself by  borrowing for more education or to consolidate debt. Each may put you in a hole initially, but you’ll be better off in the long run for having borrowed the money.

Taking out a Mortgage

The king of all debt is a mortgage. For one thing, you have to live somewhere. For another, you might as well live somewhere that increases in value almost every year.

After holding flat for most of the 20th century, housing prices began a steady climb in 1968 until the mid-1990s, when they started rising like the approach to Mt. Everest, peaking in November 2006. According to the Bureau of Labor Statistics, a house purchased in 1967 for $100,000 would have cost nearly $681,000 in 2006. Housing values easily outpaced inflation for the same period.

Yes, the real estate bubble burst in 2008 and temporarily made us reconsider home ownership as the storehouse of American wealth. But look what’s happened since the bleak bottom of the Great Recession in 2010: Houses are back, big time, prices rising 27.25%. In 2020 alone — in the midst of our national coronavirus lockdown — home prices surged 10.8%, according to the Federal Housing Finance Agency.

The strength has been steady. Having shaken off the worst effects of reckless, predatory subprime lending, FHFA reports house prices have risen every quarter since September 2011.

What’s all this mean in real money?

If you buy a home for $235,000 and it appreciates 3% a year, it will be worth $485,000 – more than twice what you bought it for – when your 30-year mortgage is paid off.  If it appreciates 4% a year, that initial $235,000 investment will be worth $649,000 or almost three times the purchase price.

Now that’s quality debt.

Getting a Home Equity Loan or Line of Credit

Home equity loans and home-equity lines-of-credit are essentially cousins of a mortgage.  Borrowers secure a loan at a comparatively low interest rate using the equity — the value above the mortgage balance — of their house as collateral.

A lot of consumers take home-equity based loans to pay off higher-interest debts, such as credit cards. Some use it to make home improvements like solar panels that could save money on utility bills and increase the value of their home.

The gambit isn’t entirely stress free: Failure to keep up the payments can result losing your house to foreclosure.

Getting a Student Loan

If you want a good education and need some help paying for it, you have plenty of company. The student loan industry is expanding faster than Homer Simpson in a doughnut shop. The $1.6 trillion Americans carry in student loan debt ranks No. 2 on the scale of the nation’s consumer debt, behind only mortgages. Student debt is more than double credit card debt ($756.3 billion).

Borrowers also may be souring on the tradeoff of debt for higher education. In April, CNBC reported on a survey of 1,000 30-something Millennials, 52% of whom say their loans weren’t worth it.

Well. It’s worth it if – and it’s a big if – you are buying an education that will lead to a well-paying career. Full-time workers over 25 with only a high-school diploma had a median weekly income of $789 in at the midpoint of 2020, according to the Bureau of Labor Statistics.

The median weekly income for workers with at least a bachelor’s degree was $1,416. But you must have the right degree.

So with apologies to Waylon Jennings, mamas let your babies grow up to be petroleum engineers ($92,300 a year after graduation), electrical engineers or computer scientists ($101,200), operations researchers ($78,400), or metallurgical engineers ($79,100), according to a 2020 PayScale report.

Anything in the so-called STEM fields (science, technology, engineering, and mathematics) has high earning potential.

On the flip side, you might never pay off your student loan if you major in liberal arts. A psychology grad starts at about ally$42,000 a year when they enter the real world.

If your dream is to major in photographic arts or philosophy or  human development, your friends may tell you to pursue it. Your financial advisor will not.

Small Business Loan

If you want to get really, really rich, your chances are much better if you start your own company and work for yourself. Entrepreneurism is all the rage, and ideas for proven small businesses abound. But have a plan, and maybe some personal backers. Small business loans are tougher to get because they are riskier to the lender.

Almost one-third of small businesses fail to survive their first two years, according to the Small Business Administration. But if you have enough ambition, savvy and luck, borrowing money to start your own business could be the best investment you’ll ever make.

 What Is Bad Debt?

Spotting bad debt isn’t all that difficult. If it loses value the moment you take ownership, it’s bad debt. Unfortunately, that describes many of life’s basic necessities, like clothes, automobiles, and that bad boy 80-inch UHD TV you need to watch NFL games.

If you can’t pay cash for them, you should at least consider settling for off-brand clothes, a gently preowned car, and 54-inch TV.

Here are examples of bad debt.

Credit Cards

Plastic can ruin your financial health, and interest rates are the silent killer. Figuring them out is confusing, and that’s fine with credit card companies. If consumers knew how much they actually pay for the privilege of using a card, they’d storm the mansions of every card company president.

Remember that 80-inch UHD TV? Say you got very, very lucky and found one at an open-box sale for $1,200, and you put on your Visa with the 18.9% interest rate.

If you paid $60 a month (which would be more than the minimum required), it would take 63 months to pay off and cost a total of $1,676.98. That’s a hefty premium to watch Trevor Lawrence in ultra-high definition.

U.S. households carrying credit card debt from month to month ticked up to 43% in 2020, from 37% in 2019. At the same time, average credit card debt per borrower slipped by 12%, to $5,111 (from $5,835).

That’s an encouraging trend, but if you are among those using more than 30% of available credit, your credit score is going to suffer. That means higher interest rates when you apply for a loan or new credit.

Payday Loans

As bad as credit cards are, payday loans are 10 to 15 times worse. You get short-term cash to get you through a crisis. In return, you post-date a check, hoping you can pay off the balance when your next paycheck arrives (typically two weeks).

It’s quick and easy, but the finance charges range from $15 to $30 for every $100 borrowed. A typical two-week payday loan with $15-per-$100 fee equates to an annual percentage rate of 400%. If that doesn’t induce nausea, forget the gastroenterologist; you need to see a psychologist (they can use the business).

Automobile Loans

Financing a car generally is considered bad debt because, unless it’s a 1966 Mustang or some other collectible, car values drop 20% less than a half-mile off the lot.

On the other hand, automobile interest rates are comparatively low (1.4%-2.5% for new with good credit; 2.5% and up for used), and if you need a car to get to work, well, a guy or gal has to earn a living.

The most financially prudent move is to avoid splurging on a Mercedes when a Hyundai will do. If you want eventually to afford that SL 550 Roadster, you’ll need what debt you have to be good, so pay this loan off on time.