Good Debt vs. Bad Debt
In this sense, all debt is the same: We take now and we give back in the future. But because debts can have positive or negative consequences, they are typically thought of as a good debt or a bad debt.
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The one thing that keeps most Americans up at night is not a lumpy mattress or getting chased by a naked Bill O’Reilly in a dream.
It’s the Big D – Debt.
More than 53% of workers stress over finances, according to a 2017 survey by PricewaterhouseCoopers. That shouldn’t be surprising since the average U.S. household with debt owes $134,643.
All this has given Big D a bad name and made it the major cause of stress for Americans, but not all debt should keep you up at night worrying. In fact, some forms of debt should let you dream of a more financially secure future.
To paraphrase the Declaration of Independence, all debts are not created equal. From mortgages to credit cards to student loans, there are good debts and bad ones.
What’s the difference?
A simple rule is 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 up all your monthly debt payments and divide them by your monthly gross income 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 should be losing sleep.
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 over 43 percent.
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
There is probably no better debt than a mortgage. For one thing, you have to live somewhere. For another, you might as well live somewhere that gains value every year.
Housing prices increased an average of 6.4% a year from 1968 to 2004. The money train pretty much derailed when the mortgage bubble burst a few years later and brought on the Great Recession.
The market has recovered, with the median home value in the U.S. hit $196,500 in March of 2017, according to Zillow.com. That was a 6.8% increase in a year and continued an upward trend that began in 2012.
What does that mean in real money?
If you buy a home for $235,000 and it appreciates 3% a year, it will be worth $485,000 when your 30-year mortgage is paid off. If it appreciates 4% a year, that initial $235,000 investment will be worth $649,000.
Now that’s good debt to have.
Getting a Home Equity Loan or Line of Credit
These are basically offshoots of a mortgage. You get a loan using at a relatively low interest rate using your house as collateral.
A lot of consumers use that to pay off higher-interest debts like credit cards. Some use it to make home improvements like solar panels that could save money on utility bills and increase the value of your home.
The only stress comes from the prospect of having your house foreclosed if you can’t make the payments.
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 Elvis in a doughnut shop. Americans carry more than $1.4 trillion in student loan debt, which is about $620 billion more than the country’s total credit card debt.
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 worker over 25 with only a high-school diploma had a median weekly income of $679 in 2016, according to the Bureau of Labor Statistics.
The median weekly income for workers with bachelor’s degrees was $1,435. But you have to have the right degree. So with apologies to Waylon Jennings, mamas let your babies grow up to be petroleum engineers. They make an average of $96,000 a year coming out of college, according to a 2017 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 makes about $29,000 a year when they enter the real world.
If your dream is to major in Photographic Arts or Philosophy or Women’s, Gender and Sexuality Studies, 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. 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?
Anything that decreases in value the minute after you buy it, is bad debt. Unfortunately, that describes many of life’s basic necessities, like clothes, automobiles and that 60-inch flat screen 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 and 43-inch TV. Here are examples of bad debt.
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 are actually paying for the privilege of using a card, they’d storm the mansions of every card company president.
Remember that 60-inch flat screen TV? Say you got lucky and found one at a scratch-and-dent 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 Tom Brady in high definition.
The average household with credit card debt has a balance of $16,784, according to a 2016 NerdWallet survey. That indicates a lot of people are way over the recommended 30% credit utilization ratio.
That also means if you’re 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.
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, which is 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, you need to see a gastroenterologist.
They are generally considered bad debt because, unless it’s a 1966 Mustang or some other collectible, cars are worth less a half-mile off the lot. On the other hand, automobile interest rates are relatively low 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 to eventually be able to afford that SL 550 Roadster, you’ll need what debt you have to be good so pay this loan off on time.
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