“Debt–the Good, the Bad, and the Ugly” – Part 1

There are three types of debt, “Good”, “Bad”, and “Ugly”. Let’s discuss the differences and provide some direction for addressing your debt-related issues.

When discussing debt with clients, too often they express a sense of guilt or shame that they owe money. One of the first rules we teach is “No Shame, No Blame”. While we do want clients to be free of debt, let’s be clear on one thing: some types of debt are defensible, perhaps even desirable. So let’s dispense with the guilty complex, and the destructive habits of blaming past bad decisions, and focus on greater clarity and understanding of debt.

Good Debt

For at least a moment, forget what those television gurus tell you about paying off your mortgage. They are not necessarily addressing your specific situation, and it is blatantly misleading to pass off such advice as applicable to all. The simple truth is that most of us could not purchase our homes but for the availability of “cheap” mortgages.

Why might it be best for you to carry mortgage debt? There are three primary reasons:

1. The use of borrowed money, or leverage, allows one to purchase much more home than would be possible if paying with cash–which, in turn, means that one will benefit much more from appreciation of the property over time.
2. Mortgage interest is fully tax deductible for most middle-class Americans, reducing the after-tax “cost” of this debt by approximately one-third.
3. Mortgage debt is a hedge against inflation (and is better than gold in this respect because you can live in your house). Paying a locked-in interest rate for 30 years, while inflation eats away at many other investments, is a vital benefit.

Other possible kinds of good debt include loans for education since the debt increases future earning; automobile debt, if you cannot possibly buy a car for cash and don’t buy more car than you need, even at 0% interest; and, in rarer circumstances, debt incurred for investment purposes.

Bad Debt

Even mortgage debt can be bad debt if the interest rate is pretty much anything more than 1% higher than the rate you can readily obtain at the present time (depending, of course, on how long you plan to stay in your house). In this situation you should consider refinancing immediately.

Bad debt generally also includes car loans (the longer the term, the worse the debt), boat loans, vacation house loans (interest is possibly deductible, but you are also probably not using the house enough to be carrying debt on it)–anything involving the payment of interest that is unreasonably high, that is not tax deductible, or that is not for “essentials.”

Ugly Debt

Put as simply as possible: Unpaid credit card balances constitute the absolute worst kind of debt imaginable. Just as compounding interest works meaningfully to your advantage when you are saving for retirement, the compounding of credit card interest charges puts you on a debt treadmill that can be very difficult to escape. While difficult, it certainly is not impossible!

Generally speaking, it doesn’t take much to convince clients to pay off their credit card debt–but that’s the easy part of the equation, isn’t it? The real work comes in making a plan to pay this debt off and then sticking to it. Stay tuned for Part 2 when we explore specific strategies to eliminate “bad” and “ugly” debt.

And don’t forget – as part of our unique service for homeowners, we provide complimentary reviews and debt elimination plans. Just contact us to schedule!