Good Debts
I'm not going to lecture you. You know all about the downsides of debt. You know that you shouldn’t run up a credit-card tab for a trip to Tahiti, and you know that such behavior has helped you push bankruptcies to an all-time high. But all the doom saying and admonishment about debt has obscured a dirty little secret of financial planning. Sometimes debt is good.
In fact, you can go overboard avoiding it. Eschewing debt at all costs, experts say, could actually prove quite costly if it leaves you with no cash in reserve for an emergency. “No one can say, ‘I won’t lose my job.’ Or ‘The hot water heater? Nah, that never breaks,’” warns Debt Counselors of America. “There’s always an accident waiting to happen.”
In fact, you can go overboard avoiding it. Eschewing debt at all costs, experts say, could actually prove quite costly if it leaves you with no cash in reserve for an emergency. “No one can say, ‘I won’t lose my job.’ Or ‘The hot water heater? Nah, that never breaks,’” warns Debt Counselors of America. “There’s always an accident waiting to happen.”
Now we’re not advocating rampant spending, so don’t take this as our blessing to hit the mall (or the road to Tahiti). Instead, it is recommended that you learn to separate good debt from bad debt. Financial planners will talk about “needs analysis” or some other jargon until you’re glassy-eyed, but it’s not that complicated.
Good debt is what you use to buy anything you really need (a home, a car or education, for instance) but can’t afford without wiping out your bank account or liquidating your investments. Of course, you must also be able to afford the payments. (Those same financial planners would suggest keeping total debt and housing payments at no more than 36% of your income.) The final key to good debt is the form it takes: High-rate credit cards, for example, are invariably a terrible way to carry debt.
But those cards notwithstanding, today’s low-interest rates on most loans make debt especially affordable. If you have the cash, the decision to borrow hinges on a comparison of what you’ll spend in interest with what your savings could earn. Take a mortgage rate of 7.1%. Given the deductibility of mortgage interest, your after-tax borrowing cost would be 5% if you’re in the 28% bracket. Earning more than 5% shouldn’t be hard. The same goes for a 9.37% 10-year home-equity loan, which amounts to 6.75% after taxes for folks in the same bracket. The interest on car loans however is not-tax-deductible, so your investment would have to beat the recent 8.84% average outright to make borrowing the right choice.
Good debt is what you use to buy anything you really need (a home, a car or education, for instance) but can’t afford without wiping out your bank account or liquidating your investments. Of course, you must also be able to afford the payments. (Those same financial planners would suggest keeping total debt and housing payments at no more than 36% of your income.) The final key to good debt is the form it takes: High-rate credit cards, for example, are invariably a terrible way to carry debt.
But those cards notwithstanding, today’s low-interest rates on most loans make debt especially affordable. If you have the cash, the decision to borrow hinges on a comparison of what you’ll spend in interest with what your savings could earn. Take a mortgage rate of 7.1%. Given the deductibility of mortgage interest, your after-tax borrowing cost would be 5% if you’re in the 28% bracket. Earning more than 5% shouldn’t be hard. The same goes for a 9.37% 10-year home-equity loan, which amounts to 6.75% after taxes for folks in the same bracket. The interest on car loans however is not-tax-deductible, so your investment would have to beat the recent 8.84% average outright to make borrowing the right choice.
Read More On Related Post
RSS Feed
