Good Debt. Bad Debt. Smart Debt.
Debt’s bad, mmm'kay? That’s what we’ve been taught all our lives, much like our predecessors before us. Debtor’s prisons were ubiquitous in America until 1833, when incarcerating penniless debtors was banned by federal law. But that’s federal law. Currently, there are seven states in the US who will still put you in jail for failure to pay court fees, rent, or in some cases, medical bills.
Debt that’s not used intentionally has always created problems for the borrower. It usually means you've purchased something that was beyond your means, and puts you in the precarious situation where compound interest is working against you. Conversely, using debt to your advantage is an essential part of financial planning. It builds good credit and allows you to acquire assets you wouldn’t otherwise be able to afford. The important thing for borrowers to remember is to use debt carefully and to your advantage, and have a clear plan to pay it off.
Debt that’s managed efficiently yields significant benefits for the borrower. It will increase your credit score, enhance your reputation (your credit score is now part of academic, professional and financial background checks) and allow you to get better rates on financing. You just have to be intentional.
Student loans often qualify as good debt. And if you have a clear reason why you want to go to college, to become a doctor or a graphic designer for example, the odds of your investment paying off increase greatly. On an aggregate scale, those with a bachelor’s degree earn over $1,000,000 more during their lifetime than those with just a high school diploma. On a more personal scale, attending college is making a serious investment in yourself, albeit one that comes with a hefty price tag. A $100,000 student loan at 3% with a 10 year payback will cost you about $16,000 in interest, and $1,000 a month. Whether you’re able to start paying if off right when you graduate or if you need to defer or use an income-based repayment plan, creating and keeping a schedule will minimize your interest payments and speed up repayment. And if you made this investment with a specific purpose, the ceiling on your lifetime earnings will not only be raised, but you’ll have opened the door to pursuing your chosen career.
Buying a house is another example of good debt. Of course, buying a house you can’t afford is not, but we’ll get to that later. Primary residences tend to increase in value. And unlike renting a home, you are building equity with each monthly (mortgage) payment you make. Without a loan, a house would be virtually impossible for most of us to buy. So, as you pay down your home loan and your house goes up in value, you are building up your net worth.
How much house can you afford?
There are a number of ways to determine if you can afford a particular house or not, but the most popular is the housing expense ratio. This is what underwriters use as part of their due diligence process for loan applications. The ratio compares your pre-tax income to the sum of your mortgage + property taxes + home insurance + association fees (the total monthly fees you’ll take on by buying the house). The target ratio is 28% or less. The underlying idea is that a lower expense ratio means the borrower will have a much easier time paying off the loan. If the ratio moves past 28%, you are looking at a house that you probably can’t afford.
Taking a loan to invest in yourself or to purchase a comfortable home for your family provides countless other benefits as well. But strictly from a risk/reward perspective, these debts are generally well-worth the monthly payments.
Debt can move to the bad column when it’s attached to a volatile asset like an investment account, or used for a status purchase that will depreciate significantly over the course of the loan. Bad debt is a liability that can hang over your balance sheet for a long time, or worse.
Margin accounts can be employed for sophisticated institutional trading strategies or to expedite cash flow, but for many individual investors, they’re an easy way to take on bad debt. The appeal of a margin account is that you can buy more shares of a stock than your account balance would allow. The mistake people make, beyond simply overextending themselves, is not understanding how they work.
A margin account is a loan from your broker, using your account balance or a deposit as collateral. Because this is a loan, the broker charges interest, in addition to commissions on all your margin trades. Once you’ve made a trade, the broker monitors your account balance to make sure it doesn’t fall below a certain value, known as the maintenance margin. If it does, the broker can demand additional funds to meet the maintenance margin, known as a margin call. Failure to fund your account gives the broker a green light to close your positions and liquidate assets in a forced sale. To make things worse, margin calls typically occur when stock prices are falling, so a forced sale will lock in your losses at the worst possible moment. It’s also worth noting that failure to pay off your margin debt can damage your credit rating, increase your home and auto insurance premiums and lead to legal action from the brokerage.
High-end cars and boats are adult toys that are often the culmination of a lifelong dream, and can bring owners lots of joy. Be it a Lamborghini or a yacht, big ticket status purchases are also surefire ways to accrue bad debt. The key features of a status purchase are that a high-quality, more affordable option is available, it depreciates significantly the second you buy it and it’s very expensive to maintain and insure.
Let’s say you need an SUV. You could get a Porsche Cayenne for $100,000 or a Honda CRV for $30,000. Price tags aside, the Porsche will require a bigger loan with a worse APR, higher insurance rates, and higher maintenance, repair and fuel costs. It will also depreciate faster. And regardless of which car you get, you're probably going to finance it with a 5 year loan. But oftentimes, by year three or four, the thrill is gone, and you still have plenty of payments left. And because of depreciation, if you sell it or trade it in, it will be for a significant loss. Now, we'll admit, the CRV is not a high-performance vehicle with a 335hp V-6 engine, but when you’re going to Costco, does it really matter?
Or consider a boat. In addition to the purchase price, there’s mooring, transportation, licensing and storage expenses. But if your heart is set on getting a boat, go for it! Just do yourself a favor and buy it in cash. Because if you take out a loan, it means adding years of interest payments to the other recurring costs, plus the maintenance and repairs you’ll be making for as long as you keep it. And, of course, each year it will depreciate in value. Perhaps it’s worth recalling what are said to be the two happiest days in a boat owner’s life - the day he buys it, and the day he sells it.
Buying nice things that bring you joy are not bad decisions. We’re just pointing out that when you take out loans to pay for them, status purchases come with an enduring cost, and often with depleting value, both financially and in terms of the value you get out of it.
Intentionally using debt should be part of everyone’s financial plan. From building good credit to increasing your lifetime earnings to buying a forever home for your family, successfully managing debt can greatly improve your quality of life and your prospects for the future. Successfully managing debt opens doors for business loans, home improvements and many other projects you may wish to take on. Good credit also makes your next project an investment banks will want to make, and can provide you with leverage when it comes to negotiating terms.
If you’d like to discuss how to integrate debt into your financial plan, click the button below to schedule a meeting. We’d be happy to talk through your situation.
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