Good Vs. Bad Debt
Have you ever eaten too many holiday cookies? The first two or three send you to heaven. But as you eat seven, eight, nine … not so heavenly. You’ve had too much of a good thing.
Debt is a lot like cookies in that regard. It can be a great thing— when it allows you to invest in your future. But it can also be detrimental when you take on too much of it. Like most things, it’s best in moderation.
So, how do you know what debt to avoid and what debt to consider? At the risk of over-simplifying, let’s split it into two categories: Good Debt and Bad Debt.
Good Debt: /ɡo͝od det/ noun; owing money at a reasonable interest rate for a productive reason.
Grace decided to take on good debt to attend graduate school to become a neuroscientist.
THINK: Mortgages and student loans.
Bad Debt: /bad det/ noun; owing money at a high interest rate for a non/less-productive reason.
Brad has a significant amount of bad debt after charging a jet ski to his credit card on top of his existing balance.
THINK: Rolling credit card debt and unsecured personal loans.
Good Debt: An Investment in Your Future
Good debt (e.g., student loans and mortgages) is an investment in something that will provide value to you down the road. By taking on student debt, for example, you are investing in yourself and your potential. By purchasing a home with a mortgage, you are investing in your stability and comfort (not to mention in the real estate market). You expect the return to outweigh the cost of borrowing the money: your interest expense.
Bad Debt: Too Much of a Good Thing
Bad debt is used for convenience. Borrowers do not expect to earn any return from taking on bad debt. The most common type of bad debt is credit card debt. Carrying a balance on a credit card can jeopardize a person’s financial wellness. (To clarify, credit cards are a great way to make purchase. The key is to pay of the entire balance each month to avoid being charged interest.) Bad debt is often incurred when purchases are made without sufficient funds to pay the cost: living outside your means.
How Much Is Too Much?
Graduating with student debt is manageable when there are jobs to take and dollars to earn. However, taking on substantial student debt to earn a degree that leads to a lower paying job, or to a job market with few openings, leads to a financial stomachache. (For more on managing student debt or to calculate your repayment plan, click here.)
And finding the perfect home to purchase is daunting, but when you do, you are through the moon. That is short-lived if you no longer can afford to go to your favorite yoga class or eat at the best food truck in the city. By taking on too much home debt, you make yourself house-poor. You have a beautiful home with financial value but not the liquidity to do the things you want to do.
Moderation is key, so it’s important to consider how much debt is too much. Going back to our Christmas cookie example, it would be great if someone warned you that the next cookie you ate would be the one that caused the problem, but that just doesn’t happen. Luckily, with debt, there is a good metric to get a sense for that fine line of “too much”. Your debt-to-income ratio helps you consume an appropriate amount of debt. Reference the formula below to calculate yours, or use this calculator.
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.
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 painful stomachaches along the way.
This post was written by a member of the Plancorp Women’s Initiative, which strives to advocate for clients and women in the community by addressing topics specific to their financial lives. For more information about the Women’s Initiative and how you can get involved, email firstname.lastname@example.org or visit the Plancorp Women’s Initiative page.
- Financial Advisor Magazine invited Sara Gelsheimer, Wealth Manager and Founder of Plancorp's Women's Initiative, to share her insights at the 3rd Annual "Invest in Women" Conference. Read more…