Debt is truly a double-edged sword – a blessing when used thoughtfully and selectively, but a curse when overused and relied on indiscriminately. With so much potentially at stake, anyone who’s considering taking on debt in any form should have a clear understanding of the distinctions between good debt and bad.
Here’s a look at the two sides of debt – financially constructive and financially destructive.
Essentially, with good debt, you’re taking on more debt, but at no additional cost (interest), which in turn frees up funds to pay down a debt that will mount (compound) much more quickly because of a higher interest rate.
Generally, student-loan debt is constructive debt because it enables you to acquire skills that give you an opportunity to earn more money. Essentially, you’re investing to improve the value of your own human capital. However, too much student-loan debt can negate that added value and turn good debt into bad – especially in cases when a graduate lacks the earning power to pay down their debt obligation.
A home mortgage also generally falls into the good-debt category. Tax breaks often accompany a mortgage, and the home might appreciate in value, which can make it a wise investment. But a home mortgage can fall into the bad-debt category in cases where the homeowner takes on more debt than they’re comfortable assuming or capable of paying off.
Zero-interest offers on car loans, credit cards, etc., can represent a positive use of debt, provided the person assuming the debt takes advantage of the zero-interest benefit. “Zero interest” means a loan with no interest (but often for a limited period of time). In the credit card scenario, transferring the balance on an interest-bearing card to a zero-interest card can save hundreds, even thousands, of dollars. A zero-interest auto loan also can save you a significant amount of money in interest over the life of the loan.
Sometimes good, sometimes bad debt
Credit card debt generally is neither good nor bad; it’s merely a tool that increases a person’s purchasing power. But that comes with one big caveat: the credit card holder must commit to paying off all or most of the card balance each month. By doing so, they not only avoid running up a large and mounting balance, but they build their credit score as a result of their positive payment record, which in turn helps to secure lower rates on a mortgage, car loan, etc.
On the other side of the coin, failing to pay down credit card balances in a timely fashion can quickly turn credit card debt into bad debt. The balance on a credit card that carries a 20% interest rate can grow fast, creating a debt hole that can be difficult to escape.
Bad debt is debt that has no future benefit. Bad debt not only lacks any benefit, but it also can bring serious and lasting financial headaches.
Credit card debt can turn destructive when the cardholder lacks the cash to pay off the balances in full, or almost in full, each month. Given the high interest rates that many cards carry, those balances can quickly escalate (due to compound interest) and become problematic. Credit card debt often becomes a problem for people who rely on plastic to cover basic expenses.
In a recent poll, “CNBC Make It” found that for almost one-quarter of Americans, basic necessities, such as rent, utilities and food, contribute most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt.
A lack of awareness could be part of the problem. In a survey by U.S. News & World Report, 21% of consumers didn’t know if they had debt and 30% were unaware of how much credit card interest they pay each month. Also, 24% were found to be carrying credit card balances exceeding $10,000. Among those polled, 13% say credit card debt causes them to struggle to make ends meet.
Another consideration when contemplating taking on debt is the psychological aspect: carrying debt can stress an individual, as well as a relationship.
For advice on how to get the most out of good debt and avoid the bad, seek out the support of a Certified Financial Planner. To find one in your area, consult the Financial Planning Association’s searchable national database, at www.PlannerSearch.org.
JASON E. SIPERSTEIN, CFA, CFP, is the president-elect of the Financial Planning Association of Rhode Island and president of Eliot Rose Wealth Management. He can be reached at email@example.com.