Debt

Should You Take on More Debt? Pitfalls and Benefits of Good Debt Vs Bad Debt
By Ernesto Sidi

Generally speaking, debt is something nobody likes or wants to have. Living debt-free has become sort of an iconic symbol of financial well-being in the US, often used as a cliche. That's probably because we have a credit debt epidemic in this country. While debt is seen as a bad thing we should all try to avoid, it can also be good for several reasons. Good debt can help you make purchases today that you could not otherwise make using cash, such as real estate or cars in most cases. But there are other not so obvious situations when debt is good.

Rule of thumb should be that debt is good any time that getting into debt will cost you less in the long run than paying cash or not making the purchase at all. For these criteria to be effective, you have to decide on a case by case basis after considering for each specific situation if the cost of debt is less than the cost of using cash or the cost of not making the purchase.

Cost of Debt The cost of debt is the interest rate that you will pay for the loan. In a mortgage, you have the annual rate and any discount points. If you choose to buy a washer and dryer on a new credit card, consider the annual rate plus any annual fees. Sometimes small purchases of appliances are offered at 18 month with no interest financing; these are great deals, but must be paid off before the period is up to avoid finance costs.

Cost of Cash The cost of using cash is not so straight forward. If you use cash, then you have to come up with the full payment right away. That may be impossible if the purchase is very large, unless you take away from your savings. If you don't have savings, then you may not get to make your purchase, or debt financing is your only option. Suppose your savings account pays you 4% per year in interest income.

That would be the cost of using your savings, the opportunity cost, or potential loss of income. If you keep the money in savings, and decide to use debt financing, suppose at 7%, the cost of using debt is the difference, or 3%. In this example, it's better to take the savings, lose the 4% return, but avoid the 7% finance cost. If the reverse were true, suppose the savings account paid you 7%, but the cost of financing were 4%, then take on the new loan and you are still making a 3% return.

Opportunity Cost The cost of not making the purchase would be the opportunity cost lost by not having what it is that you were considering to purchase. That is, any income that you could potentially make from making the purchase. Say you want to borrow money from the bank at 4% per year, and you plan to put that money in an investment that returns 6% per year. That would yield 2% earnings on that money. The cost of not incurring that debt is the 2% that you will not make. A more common example may be opening up a business.

Say you need $10,000 to open up a small hamburger stand, and you project that within 3 years you will have doubled your investment. That would yield a 33% return. If you can get the $10,000 at less than 33%, then it was good debt. Another great example would be student loans. Say you are finishing up your undergraduate degree and your remaining 2 year's tuition is $30,000, but you can't afford to pay it out of pocket. You are working full time and make only enough to get by. Do you get a student loan at 7% per year? Do the math. At 7%, it will cost you $2,100 per year, total $4,200, in finance charges.

When you graduate, you will owe $34,200, but you will potentially earn $7,000 more per year from having earned your degree. The extra $7,000 in the first year alone are more than enough to offset the $4,200 in finance charges on the student loan, so it's good debt. Not only that, if you were to not finish your degree, what will that cost you? How many years would it take to start making an extra $7,000 per year in income? If it took you 10 years without a degree, then you'd have lost $70,000 in potential income. Seems like a no brainer.

I'll give you a few examples of good vs. bad debt.

Good Debt Examples Home mortgage - Assuming that your home appreciates at a rate higher than the rate you are paying for your mortgage, this is good debt. This type of loan is also tax deductible, which is why it pays to be a home owner.

Equity line of credit - Another great source of good debt. Suppose you want to buy a used car and the dealer offers you an 8% - 3 year loan. Your line of credit is at 4.5%. You're better off borrowing from the line of credit, paying for the car in cash, and avoid financing from the dealer. That will save you 3.5% per year, plus the line of credit is amortized over several years, effectively dropping your minimum payment much lower than it would be if financed through the dealer. Your monthly payments would be lower, keeping more money in your pocket, which you can use to pay off higher interest debt, such as credit cards.

Student loan - Estimate the rate of return after you finish your degree. If you are planning to get a $100,000 veterinary degree, but will stay working at Jack in the Box after graduation, you will have a hard time paying off the student loan in a reasonable time. In the majority of cases, college graduates make far more than non-college grads, and the difference in salaries is more than enough to offset the cost of student loans. In my personal case, I made more money in my first year than the entire cost of my undergraduate tuition. I had a student loan left to pay for 10 years, but I made enough money to pay it off in about 5. If you are working towards a JD or MD, it will probably take you a while longer to pay back, but in the long run, it will pay for itself 10x.

Interest Free Purchases - These appear to be excellent deals on paper; usually at furniture and appliance stores. However, if you can negotiate a reduced price for cash payment, you may get a discount higher than the interest you'd normally pay your credit card. If the merchant is willing to negotiate, go for it. Suppose you get a 6% cash discount, and your credit card is charging you 4%, you just made 2%. If the merchant will not negotiate a cash deal, then take their financing over using your credit card.

Sometimes they also offer a no-payment for 6 month deal, which is great if you have other debt waiting to be paid off soon. A no-payment plan allows you to allocate your cash to other needs for a short period. There is always a stipulation in the contract that you must pay off the entire balance by a certain date, to avoid all finance costs. Make sure to read this and understand, otherwise you will be paying interest, and generally it's very, very high.

Borrow from Peter to pay Paul - You probably have played this game, too. I used to open up new credit cards every few months to take advantage of their limited time balance transfer offer at low or no interest rate. Then when the interest rate would kick in, I'd apply to another card and do it all over again. I'm not condoning opening up multiple accounts, but using low interest debt to pay off high interest debt is good debt. It works. But don't get in the habit, because if you get to comfortable doing this you will find that your balance keeps growing every time you do a transfer, and then you end up in deeper debt than you started.

I play this game a little differently. I use my equity line of credit, at 2.49%, to pay off my American Express, at 14.9%. I do this on a very regular basis, so my American Express account doesn't hold a high balance for more than a few days. They way I see it, after the debt has already been incurred, if you have a choice whom to hold your debt with, and if a low interest rate creditor is a viable option, switch it over.

Generate interest income or capital gains. If you find a money market or managed investment that makes a higher return than the cost of borrowing, then that would be a good debt. Suppose your bank is offering a short term CD at 5%, and your equity line of credit is at 4%. You can stand to make 1% relatively risk free. If the principal is large, so could the return. A riskier but more profitable option would be to borrow funds from a low interest account and put the funds in the stock market.

While I don't recommend this practice, I have do it with positive results. This is especially true if you know the company you are investing in, and you have good confidence that the stock price will appreciate at a substantial rate. This should be several times the interest rate you are paying for the funds, to offset the high risk you are taking. For instance, if your funds are costing you 6%, then look for a stock with a potential return of 25-50%. If you are wrong about the stock, and the amount you borrowed is large, you can stand to lose a lot of money. This could be good debt, if you invest wisely, but it could also turn into an awful experience if not.

Bad Debt Examples

High interest credit cards - Stay away from any credit cards that charge over 10%. Even 10% is high, but not as bad as some at 18% to 24%, and even some at up to 30%. There is no reason to be paying this much for credit. If that's all you have available, then you need to pay cash for all your purchases and start working on your credit. The only exception would be if you are actually paying off your balance in the same month you make the purchases, and avoid all finance costs. If you do this consistently, and make no late payments, then negotiate with the credit card company to lower your credit. Otherwise, leave the card at home, and let it sit until they drop the interest. Do not call the credit card company to close your account, as this may reflect negatively on your credit score.

High interest car payments over long periods - If your credit is good, you should demand the best available rate from the dealership. The dealer makes a commission on your financing, so it's not in their best interest to get you the best rate, unless they know you are prepared to walk away. Even 1 percentage point makes a huge difference in your total finance cost. For example, take a $30,000 loan over 60 months, at 6%, 7%, and 8%. The finance cost would be $4,800, $5,642, and $6,498, respectively. If you cannot get the best rate, find financing elsewhere. Use your equity line of credit if it's lower than what the dealership is quoting you.

If you decide to go with dealer financing, but the monthly payment is still too high, do not extend the loan past 48-60 months. The dealer will try to negotiate down to a low monthly payment, which makes the car appear more affordable. Do not fall for it, as it may turn out to be a 6 or 7 year car loan. That is a bad debt. By the time the car is 7 years old, it will have lost 75% of its value, but you'll still be paying as much as when you drove it off the lot. Also, financing for such a long period substantially increases your total finance cost.

For example, let's say you are negotiating to buy a Nissan Maxima, fully loaded, at $35,000. If you finance it for 60 months at 6%, your monthly payment will be $676 and total finance cost $5,600. That monthly payment seems very steep. If you push out the financing to 72 or 84 months, your monthly payment would drop to $580 and $511, respectively. However, your finance cost jumps to $6,763 and $7,950. The monthly payments get more affordable, but the finance cost is way too high. Common sense tells me that if you can't afford the payment, then you probably can't afford that car. Reconsider the purchase and move on.

If you really want to get the Maxima, maybe choose a different trim level without all the fancy options. If the loan drops to $30,000, 60 month financing at 6% would run you $580 per month and total finance cost of $4,800. Both are much better figures and you still get the car you wanted. The best alternative, if you can do it, is to put down a bigger down payment. Still consider where the cash is coming from and the opportunity cost of not using this cash for a different purpose.

Any debt that you are actually able to pay off immediately is bad debt. Do not keep debt around for the sake of not paying it. If you can afford it, or say you have cash saved up for something, pay down the debt and stop paying interest. Interest is like a small pin hole in the bottom of your cup, barely noticeable, but eventually it will drain your cup. I'll give you my own personal example. After I graduated from college, I was paying $185 per month in student loans. This was set for the next 10 years. It was very draining to have to make this payment every month, and it felt like it was never going to go away.

After about 5 years, having then bought my first house, I finally received a substantial tax return. I think it was about $6,000. I took all that money and paid off the remaining balance on my student loan. It was great. I avoided all the interest I would have paid for another 5 years, and also put $185 back in my pocket every month. One can ask, was that the best use of those funds? Well, at the time, yes it was.

Ernesto Sidi is the author of Cash Rollercoaster, a personal finance how-to book written for the working American. Not a get-rich book, it emphasizes strategies and methods for optimizing personal cash flow and avoiding the cash rollercoaster (repeating cycle of high on pay day, out of cash two weeks later), plus advice for paying bills on-time, avoiding overdrafts and late fees, and using leverage to create cash flow and wealth. For more information about the book, or to read other personal finance articles by Ernesto Sidi, visit http://www.pay-bills.net

Ernesto earned his Master's in Business Administration (MBA) in 2004 from Keller Graduate School of Management. He received his undergraduate degree in Electronics Engineering Technology from DeVry University in 1993.

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