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Is There Such a Thing as Good Debt?
As wealth advisors, we help clients uncover their financial and other goals when conducting our comprehensive planning process. A big part of that effort is to define what wealth means for various family members. This process can be complicated because, for most people, defining wealth is not as simple as measuring an account balance. In addition to income and assets, debt and obligations must be taken into account. Intangibles such as peace of mind or safety of principal probably should be considered. Having a high income and substantial personal assets may not make people feel wealthy if they have spent all of their money on large houses, multiple vehicles, paying for college, or supporting adult children. Even high-earning professionals may have accumulated or are helping pay student debt.
But is there such a thing as good debt? This quarter’s Planning Note explores the topic of managing personal debt through various lenses.
Good vs Bad Debt
Some may make the case that no debt is good debt. Each person has different financial circumstances, so it is difficult to determine what good or bad debt management means. For most individuals, however, tapping into one’s credit is the only realistic way to pay for big-ticket items such as houses, college, and cars. What separates good debt from bad debt is the determination of whether taking out a loan brings value that helps create income or add to net worth. (Net worth, simply stated, is the difference between what you own — your assets — and what you owe — your liabilities — and is a gauge of financial health.) Categories of good debt typically include borrowing to fund a college education, start a business, or invest in a primary residence or commercial property. In these examples, debt is used to purchase something that may have a positive or appreciating effect on net worth over time.
Paying for consumables and services using high-interest credit cards, such as vacations, restaurants, groceries, and gasoline, on the other hand, are examples of bad debt, because there is an ongoing cost to financing these purchases. Of course, credit cards generally are not a problem if you pay them off in full each month and avoid interest charges. Similarly, using borrowed money to finance a depreciating asset also falls into the “bad-debt” category. Paying interest on a new car purchase is often called “dead money” because the vehicle loses significant value the minute you drive off the lot.
Mortgages
Conventional wisdom holds that home ownership is a bulwark of net worth for most Americans. In recent years, partly in response to the housing-led financial crisis of 2008-2009, the decision to own versus rent has become less clear cut. For those who prefer to own their homes, the debt decision is fairly straightforward: pay cash, and you may gain some pricing power over the seller and own the home free and clear (no interest payments). That being said, even wealthy people take out a mortgage when interest rates are low relative to other investments that can yield better returns. Fixed-rate mortgages are generally preferred for borrowers who expect to live in their homes for a long period of time, while variable-rate (or floating-rate) mortgages may offer advantages to people who are likely to move within a relatively short time.
Mortgage interest on your main or second home is usually tax-deductible, but the rules have become strict. Notably, under the Tax Cuts and Jobs Act of 2017 (TCJA), the debt limit on deductibility for acquisition indebtedness is reduced to $750,000 (grandfathered for existing mortgages under the old higher $1 million limit), and interest on home equity indebtedness is no longer deductible. For any new mortgage debt you take on, you should consider whether the interest will be tax-deductible. Even a traditional 30-year mortgage may not have fully deductible interest if it is a cash-out refinancing and the cashed-out portion was used for other purposes than buying, building, or substantially improving the primary residence that is used to secure the loan. This may make buying and maintaining property relatively less attractive, especially in high-cost markets.
Student Loans
Student loan debt in the U.S. now totals $1.56 trillion, and the average student in the class of 2017 has $28,650 in outstanding student loans. Student loan debt can be a long-term drag on household finances — not only delaying plans to get married and having children, but also buying a house or building retirement savings. The rules governing how private student loans are repaid are some of the strictest around. Here are some available options:
- Loan consolidation — If you are carrying high balances on your student loans, car loans, or credit cards, it may be more cost effective to put all of your outstanding debt under one consolidated payment plan with a single lender.
- Graduated payment plans — Some federal student loans let borrowers pay less in the beginning of the term, and then pay more later. Graduated plans usually are limited to a 10-year term.
- Extended repayment plans — These plans let you lengthen your repayment timeline for up to 25 years, securing a lower monthly payment in the process. You’ll ultimately pay more on your loans this way, but your monthly savings can be significant.
- Private-loan company refinancing — Private student loan companies could be a viable option if you have good credit. But you may lose some of the protections that come with federally guaranteed loans, such as access to income-driven repayment plans, along with deferment and forbearance.
Paydown Sequencing
If you are stressed by your debt, there are some paydown techniques that can lessen the worry. Perhaps the most immediately effective tactic is to rein in your spending, separating your “needs” from your “wants,” and limiting your credit-card use. Next, consider paying off your highest-interest credit card or loan balances first. Another tactic is to pay off loans with the smallest balances, which may give you a welcome psychological boost and provide some light at the end of the tunnel.
If you have questions about how to better manage various types of debt, or to use debt in such a way that it leads to more positive financial outcomes, please contact me or your NAM Wealth Advisor.
Footnotes
1 Federal Reserve Bank of New York’s Quarterly Report of Household Debt and Credit Data, Q4 2018.
2 Institute for College Access and Success. https://www.forbes.com/sites/zackfriedman/2019/02/25/student-loan-debt-statistics-2019/#4e092362133f
Disclosure
North American Management Corporation (NAM) is an SEC registered investment adviser located in Boston, MA and St. Louis, MO. The information presented above reflects the opinions of NAM as of August 12, 2019 and is subject to change at any time based upon legislation change, market, or other conditions. These views do not constitute individual planning or investment advice, nor should they be relied upon to address all individual financial circumstances. Please consult with a wealth advisor to discuss your specific goals and financial situation. There is no representation that any of the statements or predictions will materialize. The data in this report is taken from sources that NAM believes to be reliable. Notwithstanding, NAM does not guarantee the accuracy of the data. Any specific investment or investment strategy can result in a loss. Asset allocation and diversification do not ensure a profit or guarantee against a loss. Past performance is no guarantee of future results.
As wealth advisors, we help clients uncover their financial and other goals when conducting our comprehensive planning process. A big part of that effort is to define what wealth means for various family members. This process can be complicated because, for most people, defining wealth is not as simple as measuring an account balance. In addition to income and assets, debt and obligations must be taken into account. Intangibles such as peace of mind or safety of principal probably should be considered. Having a high income and substantial personal assets may not make people feel wealthy if they have spent all of their money on large houses, multiple vehicles, paying for college, or supporting adult children. Even high-earning professionals may have accumulated or are helping pay student debt.
But is there such a thing as good debt? This quarter’s Planning Note explores the topic of managing personal debt through various lenses.
Good vs Bad Debt
Some may make the case that no debt is good debt. Each person has different financial circumstances, so it is difficult to determine what good or bad debt management means. For most individuals, however, tapping into one’s credit is the only realistic way to pay for big-ticket items such as houses, college, and cars. What separates good debt from bad debt is the determination of whether taking out a loan brings value that helps create income or add to net worth. (Net worth, simply stated, is the difference between what you own — your assets — and what you owe — your liabilities — and is a gauge of financial health.) Categories of good debt typically include borrowing to fund a college education, start a business, or invest in a primary residence or commercial property. In these examples, debt is used to purchase something that may have a positive or appreciating effect on net worth over time.
Paying for consumables and services using high-interest credit cards, such as vacations, restaurants, groceries, and gasoline, on the other hand, are examples of bad debt, because there is an ongoing cost to financing these purchases. Of course, credit cards generally are not a problem if you pay them off in full each month and avoid interest charges. Similarly, using borrowed money to finance a depreciating asset also falls into the “bad-debt” category. Paying interest on a new car purchase is often called “dead money” because the vehicle loses significant value the minute you drive off the lot.
Mortgages
Conventional wisdom holds that home ownership is a bulwark of net worth for most Americans. In recent years, partly in response to the housing-led financial crisis of 2008-2009, the decision to own versus rent has become less clear cut. For those who prefer to own their homes, the debt decision is fairly straightforward: pay cash, and you may gain some pricing power over the seller and own the home free and clear (no interest payments). That being said, even wealthy people take out a mortgage when interest rates are low relative to other investments that can yield better returns. Fixed-rate mortgages are generally preferred for borrowers who expect to live in their homes for a long period of time, while variable-rate (or floating-rate) mortgages may offer advantages to people who are likely to move within a relatively short time.
Mortgage interest on your main or second home is usually tax-deductible, but the rules have become strict. Notably, under the Tax Cuts and Jobs Act of 2017 (TCJA), the debt limit on deductibility for acquisition indebtedness is reduced to $750,000 (grandfathered for existing mortgages under the old higher $1 million limit), and interest on home equity indebtedness is no longer deductible. For any new mortgage debt you take on, you should consider whether the interest will be tax-deductible. Even a traditional 30-year mortgage may not have fully deductible interest if it is a cash-out refinancing and the cashed-out portion was used for other purposes than buying, building, or substantially improving the primary residence that is used to secure the loan. This may make buying and maintaining property relatively less attractive, especially in high-cost markets.
Student Loans
Student loan debt in the U.S. now totals $1.56 trillion, and the average student in the class of 2017 has $28,650 in outstanding student loans. Student loan debt can be a long-term drag on household finances — not only delaying plans to get married and having children, but also buying a house or building retirement savings. The rules governing how private student loans are repaid are some of the strictest around. Here are some available options:
- Loan consolidation — If you are carrying high balances on your student loans, car loans, or credit cards, it may be more cost effective to put all of your outstanding debt under one consolidated payment plan with a single lender.
- Graduated payment plans — Some federal student loans let borrowers pay less in the beginning of the term, and then pay more later. Graduated plans usually are limited to a 10-year term.
- Extended repayment plans — These plans let you lengthen your repayment timeline for up to 25 years, securing a lower monthly payment in the process. You’ll ultimately pay more on your loans this way, but your monthly savings can be significant.
- Private-loan company refinancing — Private student loan companies could be a viable option if you have good credit. But you may lose some of the protections that come with federally guaranteed loans, such as access to income-driven repayment plans, along with deferment and forbearance.
Paydown Sequencing
If you are stressed by your debt, there are some paydown techniques that can lessen the worry. Perhaps the most immediately effective tactic is to rein in your spending, separating your “needs” from your “wants,” and limiting your credit-card use. Next, consider paying off your highest-interest credit card or loan balances first. Another tactic is to pay off loans with the smallest balances, which may give you a welcome psychological boost and provide some light at the end of the tunnel.
If you have questions about how to better manage various types of debt, or to use debt in such a way that it leads to more positive financial outcomes, please contact me or your NAM Wealth Advisor.
Footnotes
1 Federal Reserve Bank of New York’s Quarterly Report of Household Debt and Credit Data, Q4 2018.
2 Institute for College Access and Success. https://www.forbes.com/sites/zackfriedman/2019/02/25/student-loan-debt-statistics-2019/#4e092362133f
Disclosure
North American Management Corporation (NAM) is an SEC registered investment adviser located in Boston, MA and St. Louis, MO. The information presented above reflects the opinions of NAM as of August 12, 2019 and is subject to change at any time based upon legislation change, market, or other conditions. These views do not constitute individual planning or investment advice, nor should they be relied upon to address all individual financial circumstances. Please consult with a wealth advisor to discuss your specific goals and financial situation. There is no representation that any of the statements or predictions will materialize. The data in this report is taken from sources that NAM believes to be reliable. Notwithstanding, NAM does not guarantee the accuracy of the data. Any specific investment or investment strategy can result in a loss. Asset allocation and diversification do not ensure a profit or guarantee against a loss. Past performance is no guarantee of future results.
