Debt Isn’t a Bad Word

Subtopic: Red Zinfandel Air Date: May 8th, 2020

Hands down the most common scenario we play out for clients is debt. 10 times out of 10 they get that paying off credit card debt is step one. That’s never the issue, however when it comes to low interest debt on things such as homes-businesses- specialized degrees, it’s another story.

Debt isn’t new – contrary to what most think, many writings remind us that debt is probably the oldest means of trade with cash and barter being later developments.

David Graeber , author of Debt, the First 5,000 years highlights that Some of the very first written documents that have come down to us are Mesopotamian tablets recording credits and debits, rations issued by temples, money owed for rent of temple lands, the value of each precisely specified in grain and silver. Needless to say debt has a deep rooted history and is here to stay.

This goes without saying, but certain types of debt can be downright toxic – credit cards with high interest rates and “buy-here pay-here” come with outrageous interest rates and lots of fine print. Interest rates and loan terms can drastically change outcomes- so any debt should be carefully considered as part of a long-term strategy.

Creating a Long-Term Plan

The key to debt is developing a plan that considers good debt and bad debt. Many consumers have listened to “experts” present their platitudes of debt elimination or reduction. However, every situation is different and this is not the time for one size fits all. Taking a holistic view is the perfect first step to establishing a long-term plan suited to your specific needs.

For example, a person with dependents may need life insurance to provide for them in case of premature death. In this case, what becomes priority? Naturally, mitigating the financial risk of pre-mature death should be addressed. But, too much debt could offset your ability to fund those dependents or at least significantly reduce the funds you intended on leaving them.

Or, what about the person who is not saving enough for retirement. Should they continue trying to pay down debt and ignore their retirement shortfall? This is where good planning and unbiased advice becomes invaluable.

Defining good and bad debt

It may seem like an oxymoron, but debt can be defined as “good and bad”. You can think of it like this, good debt is borrowing that supports your long-term wealth plan. Conversely, bad debt harms your credit and depletes your finances. It all comes down to risk and cost.

In our opinion, bad debt is taking on too much risk with above average cost. Bad debt is either too risky, too costly, or both.
The most common form of bad debt is revolving debt – credit card debt accounts for a huge amount of household debt in the U.S. Approximately $9,000 per household. Interest rates are high – averaging 16.46% and because it is a type of revolving credit, overuse can lead to excessive costs for products purchased.

If paid-off quickly, this can be a good use of the card. Otherwise, your lifestyle may be costing much more than you realize. Car loans are another example of bad debt because the money is used to purchase a depreciating asset.

Good debt may help you accomplish your objectives

Our first example of good debt is a home mortgage. For most people, it’s not possible to pay cash for a house. Even if you had the moolah to pay for your home, what is the advantage? Sure, you will own the home. But, you likely gave up several benefits in this decision. Debt on your home offers much more than tax-deductible interest.

First, paying your mortgage based on the terms of your loan helps build a solid credit score. Over time, equity builds in the home and you gain tax advantages along the way.

With interest rates having been at record lows for many years now, your mortgage interest is likely below 4%. Deducting your mortgage interest further reduces the cost of your loan. Instead of paying-off the mortgage early, consider long-term investment strategies that offer the potential to perform at a rate above that or your mortgage.
Student loans are another example of good debt, assuming a college degree correlates with higher earnings throughout your career. There is plenty of research that shows college graduates earn more than those without a formal education. Keep in mind, however, not every graduate follows a career that utilizes that expensive degree. If you do, and your income is significantly higher as a result, this good debt can help a borrower accomplish wealth accumulation.

Another potentially effective debt strategy involves using a loan to diversify your investment portfolio, especially for certain affluent individuals who hold a concentrated stock position in a single company. They can borrow against that concentrated position to buy stocks in other companies, making for a more balanced long-term investment strategy. An added benefit of borrowing against a concentrated stock position to diversify your portfolio is that you may defer paying the capital gains tax you would incur if you sold the concentrated stock.

Using Good debt can help you have better outcomes

Home prices rise and fall – we’ve all seen it and most of us have lived the fluctuations, however when we check things out historically, homes and real estate are great investments long term. The median price of a home in the U.S. was $79,100 in 1990 (not adjusted for inflation); nearly 30 years later, the median price has more than doubled to $193,500, according to Census data. For many Americans, their home accounts for the bulk of their net worth—and a mortgage can help you build that nest egg.

On the topic of nest eggs, I want to just show you all what it looks like to pay off that mortgage early rather than invest funds. My example is Keegan and Taylor Rosen. They’re in their mid-30s, just bought a home last year and then received an inheritance last month. What’s their knee jerk reaction? To pay off their home. Let’s look at how that plays out. We are looking at a scenario of a lump sum pay down of their mortgage vs a non-qualified investment. I kept their mortgage at a realistic if not high 3.8%. And I am running the investment pretty conservatively with a 6.15% return. Ready for the “value gained” over their lifetime? Check this out- $87k vs $1.3 mill.

Business loans

Getting a loan to start or expand a business can be a wise investment. Whether or not your business becomes the next Facebook, growing your business can help you grow your income. With careful planning, you can help to make sure that borrowing for your business is a calculated risk.

If you have income which is generated from dividends or interest in your investment portfolio, these earnings can be used pay-off bad debts. Our job is helping you assess what is bad debt and determine when it makes financial sense to quickly pay down these debts.

This is many a good argument about not having debt. Our elders used to say, a “if you can’t pay cash, you probably don’t need it”. But his logic should not be considered the universal solution for handling your finances.

Having some debt can be an important part of a long term wealth building and management strategy. Probably what our elders should have taught is avoid more debt than you can afford. It sounds simple, but your mortgage payment consumes half your salary, or maybe you decided to borrow $200,000 for higher education without a plan for career changes, things may not turn our so good. In other words, keeping your debt-to-income ratio under control is paramount.

Knowing your tolerance for debt is great place to start. No matter what your tolerance, having enough income to support your debt is a minimum requirement. We think you need to more than enough cash flow to service your debt – failure to follow this advice means small disruptions could potentially cause large problems. Determining the amount of good debt you should take on requires prudent planning and being honest with yourself. It is important to talk with a financial professional before incorporating good debt into your financial strategy.