We’ve all heard the phrase “too much of a good thing.” Usually we’re talking about something relatively harmless, but it’s a different story when it comes to borrowing money.
Should all consumer debt be avoided like the plague, or can some debt be a good thing? And at what point does “good debt” actually become bad?
In this article, we’ll define types of debts that can actually be beneficial for your financial situation, and boost your net worth in the long run.
We’ll also walk through “bad debt,” discuss some examples, guide you away from risky debt situations that could impact your financial future, and present some helpful strategies for achieving a healthy debt-to-income ratio—keeping this ratio healthy can help you reach your financial goals.
What is Good Debt?
At Plancorp, we define good debt as owing money at a reasonable interest rate for a productive reason. This type of debt has an end goal that will ultimately build your wealth in the long run. It’s an investment that will provide value down the road.
Examples of Good Debt
Mortgages
Home ownership is a long-term investment and can ultimately become one of the most significant line items on your list of assets in a net worth calculation.
Taking on a mortgage is generally considered good debt as you are investing in an asset that will likely build equity, and therefore be worth much more when it is paid off. Also, you might be able to deduct mortgage interest paid on your income tax return.
Student Loans
There is a lot in the media about the negative implications of student loans for many borrowers, but the reality is they typically have a much lower interest rate than other types of loans, and are generally a way to invest in your future (or the future of a child) to open lucrative and meaningful career opportunities down the road.
Similar to mortgages, interest paid on student loans could also be tax-deductible. However, it’s important to take into consideration the ways these good debts can go bad if not managed responsibly.
Risks of Good Debt
As it turns out, “too much of a good thing” can absolutely apply to these types of good debt.
Even in the cases outlined above where these loans are an investment in your future net worth or earning potential, borrowing too much or from poor sources can quickly turn good debt into bad.
For example, taking on substantial student loan debt to earn a degree that leads to a lower paying job, or to a job market with few openings.
Or finding the perfect piece of real estate to purchase and entering into an oversized mortgage at a high rate meaning you can no longer can afford to make smart financial decisions because of a hefty monthly payment.
This may not cross your mind as a high earner, but you’d be surprised how many find themselves house-poor by taking on too much mortgage debt. You have a beautiful home that will build equity, but not the liquidity to do the things you want to do or make other smart investments in your future.
Cash Flow Management
It's also important to consider how the minimum payments on these various liabilities will impact your overall monthly budget. A clear risk is borrowing too much and not being able to make the monthly payments in full, which could lead to significant penalties and further impact your credit score.
But covering your minimum payments is the simplest goal. You should be trying to maximize your ability to thoughtfully contribute to savings, so you don't fall into the trap of the biggest minimum payment you can afford.
What is Bad Debt?
Contrary to good debt, we define bad debt as owing money at a high interest rate or for a non-productive reason.
Bad debt is typically used for convenience. Borrowers do not expect to earn any return from taking on bad debt. Bad debt is often incurred when purchases are made without sufficient funds to pay them off.
Examples of Bad Debt
Credit Card Debt
When used wisely, credit cards can be a valuable resource. But they can quickly get out of hand when interest rates are high and you don’t keep a close eye on your spending.
The key to healthy credit card use is to pay off the entire balance each month to avoid being charged interest.
Retailer-specific credit cards can be some of the worst offenders when it comes to high-interest rates. A recent article from CNBC states that the average store-only credit cards charge an interest rate of over 30%.
High-Interest Loans: Payday Loans or Unsecured Personal Loans
Payday loans are easily one of the most dangerous and predatory types of debt. These types of loans are typically secured in a time of crisis. It’s quick, short-term cash at an extremely high interest rate (up to 75% on the initial loan in Missouri) which typically has a repayment date no more than four weeks in the future.
When you take out a payday loan, you are essentially writing a bad check for the loan amount, the interest, and any associated fees, hoping to recover the amount with your next paycheck.
If the cash isn’t there when the loan comes due, the lender can take it anyway, causing your checking account to go in the red.
Unsecured personal loans are also considered bad debt. They are risky for lenders since there’s no collateral, such as a car or home, to repossess if payments aren’t made.
This typically leads to needing a higher credit score to qualify, as well as being charged a higher interest rate. If a borrower defaults on an unsecured loan, the lender can send them to collections, or worse, take them to court.
Risks of Bad Debt
Bad debt can be a slippery slope to financial distress, and its consequences can take years to recover from.
In the case of secured loans, like auto loans for example, lenders can take possession of these assets in the event of non-payment. Lenders of unsecured loans can sue the borrower, send them to collections, and potentially have wages and tax returns garnished to cover the balance.
Failure to repay these types of bad debt can significantly impact your credit score and lead to problems in the future when it’s time to invest in good debt like mortgages.
Missed Opportunities
Here at Plancorp we work with a lot of successful individuals who are looking to level up their financial plan and align their wealth with their values.
Bad debt in the traditional sense isn’t a common concern for most of our clients, but our recommendations go beyond basic personal finance and the reality is having a high income doesn’t mean you can or should entirely avoid debt.
Things like oversized mortgages, constant car payments, unnecessary interest on revolving credit card balances or even business loans present a unique issue in the financial plans of successful people, and if not thoughtfully managed— missed opportunity.
Especially if you live in an expensive housing market, it can be easy to fall into the trap of drifting out of responsible habits. It may start with a mortgage that takes more than a third of your monthly income, which leads you to put certain purchases on high interest credit cards to incur interest, which may begin to erode your credit and impact your ability to obtain good debt in the future.
It’s one reason that working with a financial advisor can be beneficial: to have an accountability partner who helps you know what is responsible and how to build toward maximizing every opportunity.
How to Avoid Bad Debt
The best way to avoid bad debt is to have a healthy emergency fund to cover unexpected expenses. We typically recommend 3-6 months of expenses in your emergency fund, depending on your specific situation. Review this helpful article to figure out which amount is right for you.
It’s also incredibly important to have a budget. Bad debt can sneak up on you if you don’t have a strategy for spending. We recommend reverse budgeting, which helps you prioritize savings while still spending your money as you please.
Calculating Your Debt-to-Income Ratio
It’s important to keep in mind that all debt—good or bad—will factor into your overall debt-to-income ratio.
Your debt-to-income ratio plays an important role in your credit worthiness or credit score, which is commonly used in everything from improving an interest rate to employment background checks.
Your debt-to-income ratio gives you a good picture of whether you appropriately balance good and bad debt. Reference the formula below to calculate yours, or use this calculator.
Sum of Monthly Payments / Your Gross Monthly Income = Debt-to-Income Ratio
Where do you fall? In general, a debt-to-income ratio below 20% is great, and anything above 40% is a sign of financial stress. If yours is above 40%, it may be time to find ways to cut back your spending.
Debt Management Strategies
Managing debt all boils down to three simple tenants:
- Paying off existing debt (especially bad debt)
- Avoiding new bad debt
- Taking on a reasonable amount of good debt if needed
To pay off existing debt, we recommend reading this article where we compare two popular strategies - the debt avalanche and the debt snowball.
Avoiding new bad debt comes down to saving for emergencies, controlling your spending, and budgeting your income properly so you don’t need to take on these harmful types of loans. Consider alternative loan options like intrafamily loans.
In the case of new good debt, it’s important to keep in mind that lenders will typically approve loan amounts that exceed what you can reasonably afford on a monthly basis. This is why it’s important to use tools like mortgage calculators when considering these types of loans.
While you may get approval for a $500,000 home loan, maybe the monthly payment is more reasonable on a $350,000 loan. The same concept applies for student loans, credit cards, and car loans as well.
Remember just because you were approved up to a certain amount doesn’t mean you need to max that out.
Key Takeaways and Next Steps
Good and bad debt have one very key thing in common: it costs to borrow money. Keep in mind why you incur the cost, as well as your ability to make all your debt payments—and you’ll avoid financial distress along the way.
Chances are if you’ve read this article, you’re likely wondering if you’re on the right track with your finances. Our simple 2-minute analysis will help identify any weaknesses you may have in your plan and offer in-depth resources on the topics that matter most to you.
