Good Debt vs. Bad Debt: What You Should Know

December 02, 2014

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Debt is a Four-Letter Word

One early life lesson drilled into us about money comes from the Bard — “Neither a borrower nor a lender be.” Perhaps even Shakespeare might agree that the present day economy entails a more textured approach. The notion that all debt is bad fails to recognize that debt is essential to expanding balance sheets of both corporations and individuals, which also stimulates the economy.

Further, paying off debt in certain situations can be surprisingly counterproductive. One retiree who had always been told that being debt-free at retirement was critical decided to take a distribution from her IRA at retirement to pay off the mortgage on her home. The debt was $300,000, but in order to net enough to pay it off, she had to distribute about $450,000 of her $1 million IRA. The result was to forfeit $20,000 of lifetime inflation adjusted income that the $450,000 would provide if left in the IRA, leaving her with a less than satisfactory retirement lifestyle. While no one would recommend a steady habit of debt for debt’s sake, it is helpful to understand three variations of debt: Good Debt, Bad Debt, and No Debt.

The term “Good Debt” may seem like an oxymoron, but it refers to any investment where the underlying asset is appreciating in value. Purchasing an asset, such as a home or other real estate, that will grow in value the longer you own it, is an example of good debt.  As long as you are current on your payments, student loans can also be considered good debt. Pew Research Center recently found that current employed college graduates are annually making about $17,500 more than employees with just a high school diploma, which can amount to as much as $1 million more over a lifetime.

“Bad Debt” is associated with any purchase where the underlying asset is depreciating in value. Items like cars, motorcycles, and boats lose value the day you purchase them, so you don’t want to hold the debt for long.

One of the best examples of Bad Debt is credit card debt. While many of us have become savvier about avoiding credit card debt, there were still over 1 million non-business bankruptcies filed in 2013. Credit cards bring a real temptation to buy consumer goods or services to an excess, even though the goods and services may have no tangible or enduring value.

The final variation is “No Debt.” Despite conventional wisdom, having no credit at all can negatively affect you. For example, a recent widow had let her husband become the sole qualifier for credit in their marriage. When she applied for credit  in her own name, the lack of any credit history presented almost as frustrating an obstacle as having bad credit history.

Understanding the difference between Good, Bad, and No Debt may help you plan more strategically for life purchases. Just because a purchase doesn’t appreciate in value doesn’t mean that it isn’t something you need or that it is a purchase you must avoid making. It only indicates that some planning may be required. Limit purchases on your credit card to what you truly can afford to pay off each month. If you need to make a larger purchase that can’t be paid in one transaction, like buying a car, try fitting your expected monthly payment into your budget a few months in advance, so your initial down payment is larger, and you’ll be paying off the debt in less time after making the purchase.

In essence, debt is a four-letter word, so you don’t have to strike it from your toolbox if you know how to use it wisely to expand your balance sheet. It doesn’t have to be a frightening concept once you understand the texture of the debt as well as both the positive and negative implications that debt can have on your financial security.

Securities offered through FSC Securities Corporation, member FINRA/SIPC. Advisory and insurance services offered through Stavis & Cohen Financial, a registered investment advisor not affiliated with FSC Securities Corporation.

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As individual situations vary, the information presented here should only be relied upon when coordinated with individual professional advice.

Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither FSC Securities Corporation, nor its registered representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.

Deborah Stavis is a member of the DailyWorth Connect program. Read more about the program here.