The debt amount a person or entity owes to a creditor for funds borrowed is a four letter word capable of conjuring cold sweats in many Americans. However, taking on certain kinds of debt may actually be a shrewd, financially sound move.
“It is important for consumers to know the difference between good and bad kinds of debt, so they can take advantage of the good while avoiding the bad,” said FPA member Diane Maloney, CFP®.
“GOOD” debt, said Maloney, is debt “that ultimately functions as a means to increase your net worth, that is used to yield an item with long-term appreciating value,” such as real estate. It is also debt that is within one’s means to repay.
Some forms of GOOD debt:
- Tax-deductible debt. Mortgage interest is tax-deductible. Essentially you are using the bank’s money to finance the purchase of a long-term investment, a home, and getting a tax subsidy in the process.
- Debt used to finance education. Funds used to cover education costs are tax-favored in certain situations.
- Debt used to finance home improvements (new kitchen appliances, basement renovation, etc.) that increase the value of a home, as long as that increase in value is at least commensurate to the cost of carrying the extra debt. “With something like a home equity loan, you have to be reasonably confident you are not being overextended and can meet the terms to pay it off,” Maloney cautions.
- Debt used to fund a business or enterprise. Taking on debt to grow a business becomes a worthwhile endeavor if it leads to greater profitability.
- Debt used to finance a vehicle. Many people rely upon a car to get to work and earn a living.
“BAD” debt, on the other hand, is debt “that is unlikely to yield anything of appreciating value and that you are unlikely to be able to repay in a reasonable amount of time,” said Maloney, burdening the debtor with more interest/finance charges.
Some forms of BAD debt:
- Buying consumable goods including groceries, clothes, luxury items, etc. entirely on credit. While your credit card tab increases, the value of the goods you bought decreases or disappears altogether. It is better to use a debit card or cash for these kinds of purchases, said Maloney.
- Charges made on a high-interest credit card that cannot be paid off in full in the next billing cycle.
- Funding a real estate/home acquisition entirely, or almost entirely, with debt. Generally speaking, the less equity involved in such a purchase, the greater the risk to the debtor.
- Using debt to fund gambling/wagering activities is a losing proposition.
- Taking equity out of your home and investing that money in the stock market. The risks of doing so far outweigh the potential rewards, warned Maloney.