Good Debt, Bad Debt
“Debt is one person's liability, but another person's asset.” -Paul Krugman, American Economist
Kathy Longo, CFP®, CAP®, CDFA Sunday, 17 February 2019
We hear it all the time, everywhere, that Americans have too much debt. The debt of individuals 65 or older has risen 48% between 2003 and 2015.[i] The student loan debt hit $1.53 trillion in 2018.[ii] Americans now also have the highest credit-card debt in U.S. history with over $1 trillion owed.[iii] Considering that household debt hit a record high of $13.5 trillion[iv] you can see we are dragging a lot of debt around with us. What’s important to remember is that not all debt is created equal. In fact, some debt may be good.
Student Loan debt serves a purpose. Most professions in America expect you to complete a traditional Bachelor’s degree. That degree does not come cheap. College has become more and more expensive over the years, 163% more in the last thirty years to be exact.[v] But the benefit of taking on student loans, so that you may pursue higher paying careers and therefore pay off your debt eventually, makes student loans a good debt. It is an investment in your education and earning potential. Financial experts suggest children take on the debt for college, as they will have more time to pay it off in their lifetimes, rather than the parents who are closer to retiring.[vi]
Home and Car
Another good debt would be borrowing for a home mortgage. If your home purchase is a sound investment, one that you can afford and maintain, then it will add to your net worth and potentially be a source of profit if you sell it down the line. A reliable car that is practical and affordable is another positive debt. Taking out loans to help pay for large ticket items that you need and are not out of your budget are good investments. They add to your personal wealth and improve the daily quality of life.
Financing a Business
Taking out loans to start a business is another example of good debt. Getting the funds together to start a business, afford expensive starting costs, equipment, etc. is how a lot of businesses got off the ground. Having lines of credit to support the operating costs of a business can make all the difference, especially in the early stages or updating/improving as needed. For example, if you borrow money at 7% interest and put it back into the business to generate 15-20% returns, you have used your loan to increase your overall worth. Good debt can be the foundation for a more profitable business and future.
You probably noticed a theme with the good debt: it often is borrowing today to fund the future. Paying for your education, buying a family home, getting the seed money together to start a new business venture. Each of these are scenarios where you need more than you have, with the intent of paying it off over time, and for it to improve your financial situation. Bad debt is when the loans or borrowed funds negatively impact your future. When debt cannot be paid back and follows you, making it difficult to get out from under it. When you owe more than you can pay back you lose options and opportunities. College loans can become a yoke around your neck if you can’t secure good employment out of school, or perhaps left before completing your degree, leaving you on the hook for the debt without the diploma at the end. Mortgages can become bad debt if you can't afford the house you are in, or perhaps the property devalued to where you owe more than it's worth. Or leaning on loans and credit cards to get through rough patches and then being buried by the interest and fees, making it hard to dig out.
Bad Debt often comes after an unexpected event: the death of a loved one, the loss of a job, a divorce, a medical expense. When an unplanned event buts up against someone who was already stretched thin, debt often follows. A loss of a job can empty savings and max out credit cards to make ends meet for example. A divorce suddenly forces people who had been sharing incomes and homes to pay for more with less. A significant and unexpected medical expense can bankrupt a family.
How to Avoid Bad Debt
As mentioned above, so much of bad debt is caused by the unexpected. So, a good first step is to live within your means and be practical in the kinds of debt you take on. Making sure the debt is worth the risk for the long-term is a good step. Avoid getting into debt by living beyond your means with extraneous luxury spending: cars, vacations, second homes etc. should be avoided. Poor money management is often cited as the main reason people get into bad debt, so practicing delayed gratification, avoiding impulse buying, sticking to budgets, and living within your means will help significantly. Endeavoring to have emergency funds and savings to help cover any hardships or unexpected expenses is also key. Practicing frank and open communication with your spouse and children about the budget, expenses, college, retirement, long-term care etc. is helpful. Doing your research before embarking on any large debt is vitally important. Pay off your debts on time, or early, to save interest. A good rule is not to exceed 10-15% of your take-home income in debt. Once you pass the 25% mark, you will start to have issues paying it back and if an unexpected event happens, quickly get into a challenging place.
Getting Out of Bad Debt
If you are in that challenging place, the good news is there is help for you. The first step is to prioritize your debts, looking at what you owe, what the interest rate is, and where it falls on the good to bad debt scale. There are various techniques to attacking your debt, and seeking out a reputable debt counselor or financial advisor may help steer you in the right direction. Some experts suggest that attacking your costliest debts first and eliminating them will help build confidence and regain a feeling of control. Evaluating your overall lifestyle, spending habits, and creating a more austere budget may help get you on track. Downsizing and selling off valuables that are collecting dust in attics etc. may help you find funds to pay off some outstanding debt. You may have to look into bankruptcy. It can be stressful and scary to be surrounded by debt, but with real resolve, research, and the help of trusted professionals there can be a light at the end of the tunnel.
About the Author
Kathy Longo, CFP®, CAP®, CDFA
Kathy Longo brings over 25 years of expertise and experience to Flourish Wealth Management. Kathy is wholly dedicated to improving the life of each client and finds joy in making complex matters simple and easy to understand. She excels at asking the right questions, uncovering new possibilities and implementing the most advantageous strategies for success. Playing such a pivotal role in her clients’ lives remains an honor and a privilege. After earning a degree in Financial Planning and Counseling from Purdue University, she began her career at a small firm in Palatine, Illinois where she worked directly with clients while learning to build a viable, client-centric business. Over the years, she gained extensive knowledge and wisdom working as a wealth manager, financial planner, firm manager and business owner at notable, various sized companies in both Chicago and Minneapolis.