When is debt good or bad?

Daniel Hannan: “You cannot spend your way out of recession or borrow your way out of debt.”

I saw it stated that debt is a budgeting problem. But I didn’t use that quote because I do not believe that to be true. There are times when debt is good and times when debt is bad. And there are times when your only choice is debt, whether good or bad. You may ask, when is debt good versus bad?

Good debt has the potential to improve your income and net worth. An example would be mortgage payable on your primary residence. Your primary residence does increase your net worth when the real estate market is appreciating. Of note, you MAY be able to itemize the interest payments on the mortgage payable on your tax return which would reduce your taxable income. Unfortunately, that is not true for everyone due to the tax law changes in 2017 where the standard deduction was doubled. Consult your CPA to determine the deductibility of mortgage interest for you.

As for Home Equity Lines of Credit (HELOC), I’m not sure I can label that as good debt, even if only used as an emergency fund. Most HELOCs are variable rate loans, and we are in a rising interest rate environment. In addition, there is typically a balloon payment after a number of years, of which 10 years is common. Which means you will have to ‘refinance’ your HELOC in 10 years unless you have enough cash sitting aside to pay off the HELOC. And if you are making interest only payments on the HELOC due to rising interest rates, you have not made a dent in your principal on your HELOC, and then you are in this vicious cycle of refinancing the HELOC every 10 years with little paydown of principal, possibly into retirement. Now, I do not know all the ins and outs of HELOCs, but I would rather have my clients put money aside in a savings and/or investment account for emergencies and other liquidity needs. When interest rates are low, refinancing the primary residence is another option if there is excess equity in your home and it makes sense to refinance. Are you sensing a need for some financial planning?

Another example of good debt is debt on a rental property that is generating monthly income along with possible appreciation in value of the rental property. Note, the property must be generating rental income in excess of rental expenses, including major repairs to the rental property, for it to be deemed good debt. Yes, you can deduct rental expenses from rental income on your tax return, but not all rental expenses are deductible, such as the principal payments on the mortgage payable. And what is the point of owning a rental property if it is not generating net income? Okay, topic for another day.

As for bad debt, it can hurt your financial situation or put it at a standstill. Examples include, but are not limited to, credit card debt, auto loans, personal loans, and payday loans. These loans carry a high interest rate even in deflationary periods. Some of these loans can be difficult to payoff due to compounding interest even though they can be very easy to obtain if you have decent credit. Be careful with credit cards that allow 0% interest during introductory periods on purchases. First, you must track when the interest free period ends. Second, payments you make on some of those credit cards are applied to your most recent purchases. That enables your credit card company to charge interest on older purchases where the introductory period has ended on those purchases. Pretty tricky, right? And rolling over credit card balances from one card to another to continue the interest free period seems futile. You still have debt that either is ever growing or not decreasing.

Is there a way to paydown bad debt? Absolutely. But you must make it a priority in your budget. In many cases, there is a means to pay down debt but not a priority to pay down debt. Time to make changes in your habits now to thrive rather than survive in retirement. There’s no better time to start a new habit to ensure you thrive in retirement!

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