- Avoid credit card debt -- that is a no-brainer.
- Student loans can help you increase your earnings potential.
- A home mortgage is a great idea for many people.
Bad Debt Should Be Avoided, But 4 Types of Good Debt Can Improve Your Life
If your debts cause you distress, the idea of debt-free living may seem ideal. Just imagine a life with no debt:
- No payments to remember
- No one waiting to pounce with late fees if you pay a day late
- No interest costs
- Nothing but Benjamins in the bank
Ah, living debt-free is a life in Utopia, right?
No, not so fast.
Think of debt is a tool that can be used for good and bad. There are bad reasons to use debt, and good reasons to use debt. Let's look at two common good uses of debt to illustrate our point.
Good Use of Debt
Only the top 1% can buy a house without a home loan. We 99-percenters need a home loan to buy our space. Over the last 100 years, owning a home has provided a fair to good return on investment for most home buyers. However, the housing crash in 2008, which in many areas of the country sent home prices into a time machine to pre-2000, has made it appear that homeownership is a bad deal. In some areas of the country, it certainly was and continues to be a nightmare for homeowners who bought at the market's peak.
For people who plan to stay in one area for a decade or more, buying a home offers a return on investment that renting cannot match. This is because at the end of the home loan, the occupant owns the home. Over the same time period, a renter would not own the home, but instead would pay for the landlord's loan payments. Even if a home does not appreciate much in value over the life of the loan, at least a homeowner owns a large asset at loan's end.
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Also, the interest on a home loan is tax deductible for people who itemize their taxes, which is a form of government subsidy renters do not enjoy.
Of course, homeownership is a bad choice if you plan to change locations frequently to follow your career. It is also a bad choice if you want to buy in an area where housing prices are falling.
Another good use of debt is a college or trade school education. For more than two generations, the US workforce has been shifting to knowledge workers where intellectual problem-solving and technical skills are more highly valued than physical strength. One example: vehicle repair technicians need just as much skill in diagnosing electronic components in cars as they do in basic mechanics. Getting a good job today requires skills not taught in high school.
A potential pitfall, however, is overspending for education. It is not uncommon to find people graduate with four-year degrees and six-figure student loan debts, which is a very poor choice in borrowing.
|Loan Type||Why This Debt is Good||Why This Debt Might Be Bad|
|Home Loan||If you plan to live in one area for the length of your career, then a home loan will cost roughly the same as rent over time, but at the end of the loan term you will own the asset.||If your career or personal life will cause you to move from one area of the country to another. Career military personnel, for example, may find renting a cheaper, more flexible housing solution.|
|Student Loan||People with college degrees or trade school certificates earn more than people with a high school diploma only. Unemployment rates are lower for people with degrees & certificates, too.||Over-borrowing for a college degree causes a long return on investment. Borrowing for training or an advance degree when you are nearing retirement is a bad idea financially.|
|Medical Bills||Paying for necessary medical procedures to improve a person's quality of life is humane and necessary.||Borrowing for optional cosmetic surgery that does not change the person's quality of life is wasteful.|
|Business Debt||A new venture may create significant wealth for the borrower.||Over-borrowing to prop-up a failing business is spending good money after bad.|
Bad Use of Debt
Ridding ourselves of bad debt — or even better, avoiding it completely — is a good idea. But what is a bad debt? We list common bad types of debt in the table below. Bad uses of debt usually involve impulse or status purchases, or something similar that gives us an immediate gratification. For example, it is easy to get into the habit of buying expensive coffee drinks on a credit card because the cost is hidden from us. Or the other extreme, we use a home equity loan to buy a boat, motorcycle, or fancy cruise we feel we earned.
Here's another way to separate good debt from a bad debt: Most items that cause bad forms of debt are advertised on television. For example, new cars, fast-food, and high-end cellphones are pitched often on TV and have cheaper alternatives.
|Loan Type||Why This Debt is Bad||Alternative to This Debt|
|Credit Cards||Over-use of credit cards is a sign of over-spending. High credit card utilization (maxing-out an account) causes harm to a credit score.||Use a debit card or cash to keep daily spending in check.|
|Personal Loans||Used frequently, is a sign of not controlling spending. Use of payday loans, for example, is expensive.||Strive to create a "rainy day" savings account to prevent need for personal loans.|
|Vehicle Loans||Do you really need, or just want, a new car? Much of the depreciation in a new car happens in the first few years. If you work in sales ferrying around clients, then consider leasing instead of buying a vehicle for tax reasons.||Consider buying a newer used vehicle that has already endured the "first mile" of depreciation expense. Loan rates for used vehicle are not much higher than new-car loan rates.|
|Home Equity Loan||Can be good or bad. A bad HEL is used to pay for luxury items, vacations, or other non-essentials. Burdens home with additional debt. If you cannot repay the debt in the future, you risk foreclosure.||A good HEL can be used to repair or improve your home, or as an alternative to a student loan. Consider a 401(k) loan, which if unpaid, results in a tax penalty but avoids foreclosure risk.|
Debt-free living is a romantic notion that over-simplifies life today. As the two tables illustrate above, there are good uses for debt that can create wealth and opportunity. Debt can also be misused and cause financial harm to its owner.