Normally, when we look at the balance sheet, we try to distinguish good debt from bad debt. We think that good debt are things that better our financial situation (purchase a home or student loans). Thus, we think of bad debt as things we purchase that depreciate in value (clothes, vacations, etc.) which have little impact on future financial growth. I even wrote about it in a previous article on debt. This is an easy way to explain how some debt is good while other debt which should be avoided. However, there are a few issues that we are mixing in when we discuss good debt and bad debt in this fashion. Technically, once you incur debt, it does not matter what the debt was for because debt is debt which I will explain below. What gets mixed in is whether the debt was for a good investment or purchase or not. When looking at debt, the key determination is how it fits into your net worth and income. We sometimes overlook this when discussing good debt versus bad debt.
Some debt is considered good when it is used to generate a good investment return. For example, a student makes an investment when paying for a college degree on the premise that the degree will help him generate a higher income after graduation than if they did not get the degree. As with any investment, the analysis should look at:
Return from investment / cost of investment
The return on investment is the expected present value of a higher salary due to having the degree. The cost of the investment = present value of cost of college education + cost of books + cost of loss earnings while attending school + cost of debt.
For the most part, a college degree is a good investment. However, there are downside risks with an education that should be considered because they can reduce the return of the investment, including:
• Not getting a job in a chosen field (either due to an oversupply of candidates or due to lack of jobs for the degree like art history major)
• Not using the investment to its best potential by sitting on ones laurels (a degree can get someone in the door, yet college graduates still need to prove their worth)
• Not enjoying the career and deciding to take a different career track outside what he has a degree in
In addition, the lower the cost of the investment the better the return will be. Thus, a high cost private college that does not increase the return from the investment compared to the return from a lower cost public school education will lower the investment return by increasing the cost of the education. Thus, it is important to look at the investment to see if it is worth making whether or not the student loan debt is considered good debt or bad debt.
If the investment in college education is good, the second decision is to determine if the debt is good or bad. A debt at a low fixed interest rate can be a good debt. A debt at a low variable interest rate (e.g., initial 12 month credit card offer) can be a bad debt when the interest rate spike up to 12%. Thus, it is important to look at each part of the equation separately, the investment and the debt instead of combining into one decision where some college students believe that credit card debt is good debt just because it is an investment in their college years.
A purchase either decreases cash or increases debt/liability. Whether a purchase is good or bad in itself is independent of whether you use a credit card to pay for it or cash out your retirement fund. A purchase that fits into a budget comfortably whether for a need or a want is fine. A purchase that can not fit into the budget is robbing Peter to pay Paul. If a purchase (e.g., furniture) that does not fit into the current budget are usually the ones that have a problems getting paid off. If a family is living pay check to pay check where their money is already allocated, a purchase on credit card or payment plan will have a hard time being paid off. If it can not fit in the budget now, it will be hard to fit into future budgets. Thus, even if a purchase is made with a 0% payment plan (e.g., car loan), the debt may be viewed as good due to the low interest rate, however the purchase should be considered bad because it did not fit into the budget. Thus, it is important to separate out the difference of the purchase from the debt itself. Purchasing a car that you can not afford is a bad purchase whether or not you get 0% financing.
A debt is a liability that needs to be paid in the future. Once there is a debt on your net worth statement, the history of what it was for doesn’t really matter (except for if it qualifies for tax exempt interest for mortgages and student loans). The real issue with good debt and bad debt is in the key aspects of the debt itself (not what it was used for):
• Interest rate (adjusted for an tax benefits)
The higher the interest rate the worse the debt is. A low interest rate a few percent above inflation is good. For example, student loan debt around 2 to 4 percent is a great deal while credit card debt at 16 percent is a bad deal.
• Variable vs. fixed interest rate
For most families who are living paycheck to paycheck, variable debt can be disastrous. A slight increase in the rate can push a family over the edge. Even though fixed interest rates tend to be a little higher, the rate is stable, a necessity for someone living on the edge. The last thing these families need is something that rocks their financial life-raft over the edge from an increase in rates. However, for some families who can take the risk of higher payments, the lower interest rate can be beneficial. Currently, a 5-year ARM has a 0.25% lower rate than a 30-year fixed rate (which is $250 for $100,000 loan before any tax deductions). For someone who is most likely not going to be in their home in 5-years, this may be a good option (extra $250 saved) if he can handle the risk of living there past 5 years and having an increase in rates. For others, the $250 is a small price to pay to eliminate the risk of interest rates increasing. So a variable interest rate debt is bad debt for those who are living on the edge and can not handle the risk, yet can be good for families that have enough extra room in their budget to handle the risk of a variable rate for the benefit of lower payments at the start of the loan.
• Debt to income ratio
The higher the debt to income the more risk the loan has. Some say that a debt ratio should be less than 40 percent of gross income. However, the ratio really depends on your other expenses. If you pay higher costs for other things like health insurance, food, special schooling for a handicapped child, etc., even a lower debt ratio may be a problem. Thus, how the debt fits into the budget now and in the future is critical. And, you should consider what happens if your income drops. Will there be enough room in the budget to modify your expenses to fit in with your change in income? If there is a high debt ratio, this leaves little room in the budget for anything else. Thus, a higher ratio is always more riskier and considered as bad debt.
• Emergency fund
Having an adequate emergency fund lowers the risk of default and makes a debt more manageable in case something happens. In other words, having an emergency fund for times where you may hit a bump in the road is beneficial to reduce the overall risk of having a debt. Not having an emergency fund makes any debt a bad debt (because you can not handle the risks).
I bring this up because it can be easy to look at what is perceived to be good debt (mortgage and student loans) and be caught with too much debt even though educational debt and mortgages are perceived as “good” debt. The issue for debt is not what kinds it is rather how it fits into your budget. What it was for is deemed either to be a good investment and/or purchase or not. A good investment is going to make you money long term (like a college education). A bad purchase is robbing your future in the hopes of having more enjoyment now (putting vacation on credit cards without paying it off at the end of the month).
From a financial planning perspective, managing debt is just about numbers (interest rates, % of income, risk, etc.). The better we manage the numbers, the better off we will be with our debt. However, many people beat themselves up because they made a bad investment or bad purchase in the past. This guilt hinders them from managing their debt because their focus is somewhere other than on managing the numbers. The key is to learn from the lessons of the past (how to invest and make purchases) and to manage your debt in the present as if they were just numbers. Instead, of looking at what caused the debt, you need to ask how do you get out of bad debt and use good debt to your advantage. Yet, if you are beating yourself up for a bad decision (paying on a student loan for law school where you dropped out in the last semester), guilt and shame is not going to help you in managing your debt. Thus, take a look at your overall debt on your net worth statement and see how you are managing it to reduce your risk instead of looking at it as “good debt” if it was from a student loan or mortgage.