Good Debt vs. Bad Debt

“I’m in debt. I am a true American!” – Balki Bartokomous, Perfect Strangers

Debt plays a large role on our lives. Housing, transportation, education, and even daily spending needs are all financed with debt by a large number of people. According to the Federal Reserve, consumer credit (excluding mortgages) in the US stands at $2.8 trillion.

Debt is a double edged sword. Too much and you can get yourself in trouble. Not enough and it could be difficult to get ahead. What follows is my take on the best and worst ways to utilize debt.

GOOD DEBT: Credit cards can be beneficial as long as you pay off the balance every month. You can earn rewards like cash back, airline tickets or travel discounts. This is also a great way to increase your credit score by making timely debt payments and gradually increasing your credit limit.

Zero percent interest credit cards that offer you bonus rewards points can also be a great way to give yourself an interest free loan for 12-18 months. You just have to plan ahead and make sure you pay off the balance before the 0% term runs up or you will have to pay the accrued interest payments.

As long as you are paying off your balances before the banks and credit card companies can charge you interest, you get a free ride with the added benefit of earning rewards.

BAD DEBT: The absolute worst kind of debt is carrying a credit card balance. Everyone knows the pain that credit card debt can inflict, but think of it this way – if you are paying the average annual interest rate of 15% and are paying down your credit card balance instead of investing you could be losing 22% a year (assuming a 7% return on your investments). Carrying credit card debt is one of the easiest ways to ruin your finances.

GOOD DEBT: Fixed rate mortgages are usually a fantastic deal for borrowers. You know exactly the amount of money that you have to pay every single month. This does not change over the term of your loan…ever. Inflation will be a huge help to you over that time frame as your debt repayments become worth less and less over time.

As your wages increase you can grow into your payments and eventually increase the amount you pay over time. You also have the option to refinance at a lower rate, but if rates rise, banks can’t recall your mortgage to charge you higher rates. For once, you have leverage on the banks. You can also pay it off faster if you’d like to lower your long run interest payments by paying down the principal balance.

Real estate is not a great investment on average but it can be a great asset for you to build equity through a fixed rate mortgage. As long as you have your mortgage balance paid off by the time you retire, this is a perfectly acceptable form of debt.

BAD DEBT: Adjustable rate mortgages. If you have to choose between a fixed or adjustable rate mortgage, the common sense choice is a fixed rate mortgage. Since you have no way of predicting the coming interest rate environment, you should not try to use variable interest rate mortgages to game the system. These products are often difficult to understand and negate your ability to plan for the future.

Instead of knowing exactly what your payments will be looking out a number of years, you could see them rise whether you can afford a higher monthly payment or not. The risks far outweigh the rewards on this type of debt.

GOOD DEBT: Much has been written about the problems with ballooning student loan debt in recent years. Usually these horror stories involve people graduating with six-figures of debt and no job prospects to speak of. Is student loan debt really that bad for you?

Morgan Housel, of The Motley Fool, shared some interesting data on this subject in a recent article:

According to the Federal Reserve, the median student loan balance is $12,800. Seventy-five percent of borrowers owe less than $28,000, 90% owe less than $54,000, and only 3% owe more than $100,000.

Put this in perspective. The median student loan of $12,800 with a 10-year standard payback plan at 3.9% interest (the new rate on government loans Congress approved last week) will generate a payment of $128.99 per month. A graduated 10-year repayment plan would create a monthly payment starting at $72.10. Compare that to the average cell phone bill ($71 per month), the average cable bill ($70), the average monthly entertainment budget for single-person households ($137), the average amount spent on restaurant food ($153 per month), and the average amount spent on alcohol ($33 per month).

There is a heavy dose of perspective in these numbers. It’s no fun to be a slave to debt when you first get out of college, but having to make periodic debt payments can be habit forming. It can actually make you a more responsible borrower along with showing the discipline involved in making financial decisions.

Interest rates of 4% or less are not crippling over a 10-15 year period that most have to repay.

The national unemployment rate is around 7.5%. For those with a Bachelor’s Degree or higher, the unemployment rate is only 4.2%. Is student loan debt worth almost a 50% better chance at gainful employment along with an average premium in pay over those without degrees?  I’d say so. Just don’t overdo it.

BAD DEBT: Obviously, coming out of undergrad with six figures in debt is a terrible idea. You don’t want to be in the 3% category with debt in excess of $100,000 unless you go to law school or med school.  The same applies for most graduate schools as well unless you can get into a top tier program.

Like all financial decisions, debt really depends on your lifestyle and spending habits. As long as it doesn’t take up a large amount of your monthly spending plan or eat into the amount you need to save, debt can be beneficial when it’s sized correctly.

If it allows you to purchase an asset such as a house or a college degree that offer future benefits it’s not as bad as some make it out to be. You just have to be smart and put it into perspective with your overall financial plan.

Sources:
3 Economic Stories that get Blown out of Proportion (Motley Fool)
FRED Data

Further Reading:
A Behavioral Approach to Reduce Your Debt