June 26, 2018 – By Miranda Marquit
Debt is practically a part of modern life. Most people can’t get a college education without borrowing, and buying a home often requires a mortgage.
Using debt to get ahead in life isn’t necessarily a bad thing, according to Andrew Housser, the co-CEO of Freedom Debt Relief, a debt settlement company.
“Think of it as productive versus unproductive debt,” Housser said. “Know exactly what you are borrowing for and have a plan for how you will use the money.”
With that in mind, here’s how you can answer the question, “What is good debt?”
What is Good Debt?
There are two main factors you can use to determine if you’re looking at productive debt. Here’s what to consider.
Start with the interest rate, recommended Larry Ludwig, a personal finance expert and the founder of financial education website Investor Junkie.
“Look for an interest rate below 7.00%,” Ludwig said. “Typically, bad debt has an interest rate above that and no return on investment.”
Housser agreed that interest rates play a big role in whether debt could be considered “good” or “healthy,” with the caveat that productive debt should have a fixed interest rate.
“Your payments should be predictable,” Housser said. “They should be affordable within your budget so that you can still meet your other obligations and goals, including emergency fund savings.”
Return on Investment
In addition to getting a low interest rate, good debt offers a return on your investment, such as a degree, a home, improved cash flow, or another way to help you build wealth, according to Ludwig.
Housser pointed out that you should be able to continue benefitting from the debt six months down the road. “Coffee drinks and music downloads, and even vacation loans don’t exactly qualify,” he said.
Don’t necessarily consider a tax benefit a return, warned Ludwig.
“As we’ve seen recently, tax laws change,” he said. “Possible home interest deductions are icing on the cake, but they shouldn’t be the reason you purchase an investment property to take on currently deductible debt.”
4 Types of Good Debt
With that in mind, what’s good debt? Here are four investments that might be worth the cost of borrowing.
“Homeownership is an asset that can help you build equity and net worth,” said Housser. “That makes it productive.”
At the same time, though, you don’t want to get in over your head. Figure out how much house you can afford, and keep your payments low, Housser suggested.
Ludwig pointed out that getting a loan on an investment property can also be a wise use of debt. He’s used debt to purchase properties that generate regular cash flow through renters, with the added bonus of having someone else’s money building equity with each monthly payment.
When investing in property, start small. Make sure you can comfortably handle the payments and that there’s a good rental market before you go into debt, Ludwig said.
- Student Loans
Housser and Ludwig both said student loans can be worth the debt if you approach them wisely.
A degree can provide you with greater opportunities to advance in your career and make more money over time, Housser pointed out. However, it’s important to be careful about how much you borrow, whether in federal or private student loans, and the type of degree you get.
Spending $100,000 on a degree at a prestigious university might not make sense if you’re going into a low-paying field. Instead, Ludwig recommended considering your long-term return on investment and lowering your expenses by:
- Choosing a low-cost school
- Applying for scholarships
- Entering courses of study with higher-paying career prospects
- Business Debt
Loans can help you start a business that could result in long-term income and wealth. Housser said that, while there are some businesses that can be started on a shoestring budget without borrowing, other ventures require more capital.
As with other types of debt, though, Ludwig said to approach business loans carefully. Be realistic about what you need to get started and borrow no more than what’s necessary. As you begin to see revenue, you can use that money to expand your business.
A good business plan can help you direct your resources in a way that helps you grow your enterprise. Over time, you can create cash flow to pay down your debt and begin building wealth, said Ludwig.
- Auto Loans
While some experts don’t think of borrowing for a car as a good thing, Katie Ross, the education and development manager for American Consumer Credit Counseling, a financial education nonprofit, said that it sometimes makes sense to invest in a vehicle.
“Good debt can be an investment,” Ross said, “and your vehicle qualifies if you need one to take advantage of career opportunities that make up your income.”
That doesn’t mean that you should go out and buy an expensive luxury car, though. Instead, get the cheapest car you can that will get you to work. In areas where public transit is unreliable or practically unavailable, a vehicle can be a necessity. And while paying in cash is ideal, you may need a loan to afford a car.
Keep Good Debt From Going Bad
Even though some debt is considered good, it doesn’t mean that things can’t go horribly wrong.
“No debt is inherently good,” said Ross. “Even though some loans may present opportunities, no debt comes risk-free.”
Justifying debt because it’s considered good could lead you to overextend yourself. You might end up with payments you can’t afford or problems if your income is unexpectedly disrupted, for example.
Rather than taking on as much debt as a lender allows, carefully consider your needs. And make a plan to pay back your debt as quickly as possible.
If you’ve borrowed too much, Housser recommended making lifestyle changes to spend less and turning to financial tools. To make payments manageable, for example, you could use debt consolidation loans for unsecured debt, student loan refinancing for private student loans, or income-driven repayment for federal student loans.
“In the end, debt is still debt,” said Ross. “The idea of creating value down the line hinges on financial planning to eventually benefit you and your credit score.”