Depending on the “money culture” of the home you grew up in, it’s likely that you’ve encountered one of two attitudes toward debt: either you view it as a “slush fund” to be tapped when there’s something you want that you don’t have enough cash to buy; or you think of debt as an evil that must be avoided at all costs.
The fact is that neither attitude is quite on the mark. Like any other financial instrument, debt is a tool; it’s up to you to use it wisely for the purpose for which it was intended—or not. People who do the former generally do well; people who do the latter often run into trouble.
Let’s take a look at some different types of debt and their uses. Along the way, we’ll differentiate between “good debt”—when borrowing can be a smart financial move—and “bad debt”—when someone is making inappropriate use of this important tool.
First, it’s helpful to know some basic terminology. When you borrow money—whether from a bank, a friend or family member, or a credit card company—you create a liability. A liability refers to anything for which you are financially responsible for repayment: a mortgage, a car loan, a credit card balance, etc. The opposite of a liability is an asset: something you own outright and for which you have no liability: a fully paid vehicle, a piece of property, an investment account, etc. When you put your assets and liabilities on a balance sheet, the assets go on the left side, and the liabilities go on the right. To determine your “bottom line,” or net worth, you add your assets and then subtract your liabilities. Ideally, you want the total of the items on the left side to be greater than the total of the items on the right, resulting in a positive number.
Good Debt, Reasonable Debt, and Bad Debt
Now, let’s look at some of the ways debt can be used, both favorably and less favorably.
- Good Debt: 15-year Mortgage. Buying a home is probably the most important purchase any of us ever make, and for most of us, that means getting a mortgage. Two of the most important factors of any mortgage are the term (how long it takes to pay it back) and interest rate (how much the bank charges you to loan the money). If your cash flow can support it, a 15-year mortgage is optimal, because you’ll save tens of thousands of dollars in interest by paying the loan back over a shorter period of time. Use a free online mortgage calculator like the one at Bankrate.com to discover the difference.
- Good Debt: Three-Year Auto Loan. In our society, reliable transportation is a must. Unless you live in an area with a well-developed public transit system, that means you need a car you can depend on to get to work, go to the store, take kids to school, and everything else. As with a mortgage, most of us will make car payments at some point in our lives (though saving enough to pay cash is a great aspirational goal for anybody). Here again, term and interest rate are top considerations, because a car is a depreciating asset: it begins to lose value as soon as you drive it off the lot. It is best to pay off the indebtedness on your car before you have to start spending a lot on routine maintenance, which typically starts in about the third year of ownership. So, a three-year car loan is the best way to use debt in this case. With a longer term, you’ll probably find yourself making car payments at the same time you’re paying for potentially expensive repairs, and that can create tensions in other areas of your budget.
- Reasonable Debt: Five-Year Auto Loan. For the reasons stated above, a five-year car loan, while still workable, is probably less advantageous for your financial situation than the shorter term. In five years, the resale value of your vehicle (the “asset” part of the picture) is possibly still higher than the balance owed (the offsetting “liability”). But if you extend the debt much farther than five years, you’re more likely to be “underwater”: you owe more on the vehicle than it’s worth. It’s best to avoid that situation. In general, it’s best to keep total auto costs, including your car loan payment, within 15% of your take-home pay. For some standard expense guidelines including how transportation expenses fit in to your overall cash flow, click here. If you can make at least a 20% down payment on the car, that will also reduce the amount you have to repay.
- Reasonable Debt: 30-Year Mortgage. The vast majority of borrowers get a 30-year mortgage, because the payments are lower than a 15-year mortgage. The longer-term mortgage means the payments are lower but the interest rate on the loan will be higher. Locking in an interest rate for 30 years can provide tremendous savings on interest payments (if interest rates are low) and minimizes the interest rate risk if interest rates rise rapidly, as they have this year. Additionally, even if you lock in a higher interest rate at the beginning of a 30-year term you can always refinance the mortgage at a later date if / when interest rates go lower. A risk of a 30-year mortgage is, because the value of a home is subject to the cyclical movement of real estate prices, your risk of seeing your value dip below the amount you owe is greater with a 30-year mortgage. Here’s a great article that can help you understand how much you can afford to spend on your first home.
- On the Border Between Reasonable and Bad Debt: Student Loans. Taking out a student loan can be a great idea if you need income to attend school. However, more students are taking on crippling debt they cannot repay. The key to a reasonable amount of student loans is to be sure that you will make enough money when you graduate and enter your career to pay off your student debt and afford your lifestyle. Look at average salaries for persons entering your chosen field, factor in your other costs (housing, transportation, etc.), and do the math. If your total student loan debt at graduation is less than your annual starting salary, you should be able to repay your student loan in ten years or less. Get more information on educational loan repayment at https://studentaid.gov/loan-simulator/.
- Bad Debt: Credit Cards. Credit card companies exist for one reason only: to collect high rates of interest on unpaid balances. For this reason, you should take a credit card out of your wallet only if you have the discipline and available funds to pay the full balance each month. In fact, about the only way to come out ahead with a credit card is if you pay off your balance every month and then collect the rewards and incentives offered by the issuing company. Credit cards offer cash back, travel rewards and other incentives however there is no benefit to carrying a credit card balance. In other words, cash back, free flights and hotel stays are great, but not if they come with the cost of high interest payments, month-in and month-out. The bottom line is credit cards can be a great tool to receive rewards however if you use a credit card you should have enough cash available to pay off the balance or you should not be spending the funds. The goal is to avoid paying interest to a credit card company because that is money down the drain.
Let’s say it again: with any type of debt, you always need to be thinking about term and interest rate. Always evaluate the increase (or decrease) of the asset’s worth against the amount of interest you’re paying. The best way to use debt is when you are gaining an asset that will appreciate in value over time (purchasing a home). The worst way is when the debt has no asset value to offset it (most credit card purchases, for example). In other words, keep asking yourself, “What is my return on this debt?” Ideally, the answer should fit on the “asset” side of your balance sheet.