Conventional wisdom states that borrowing money for education or a home is “good” debt. Unlike using a credit card or borrowing to buy a car, schooling and your home are things that stand the test of time. No one can take your education away from you. It’s unlikely that a cargo truck will clip your home and “total” it. Theoretically, both education and a home will appreciate in value.
However, we know all too well that we can’t take that value appreciation for granted. Who would have predicted that borrowers on mass could become underwater in their homes during the Great Recession? The students who graduated just as the economy took a nosedive don’t necessarily feel like the money they borrowed for their education is going to see a return on the investment. So does that mean we need to rethink the idea of good debt?
What Makes Good Debt Dangerous
The idea that it is worth it to go into debt to further your career and own a house is not a bad one. The alternative would be to work for years at a low-paying job so you could set aside the money for college, or to live in an apartment for thirty years to save up for a house. Clearly, that’s insane. Borrowing money to do these things before senility sets in is definitely in your best interest. The problem lies with the scope of what you borrow.
Student Loan Pitfalls
Putting an entire medical school bill on student loans is a recipe for eating ramen forever. Or at least for setting yourself up for huge debt throughout your life. Students get themselves in trouble with student loans because they might not feel they can wait for their education. Putting school off for a few years while you save up is a reasonable way to keep your loans low, as is working throughout school. Without these measures, graduates are finding they cannot begin to pay their loans on the salaries they make right after college. Even living like a student is too expensive if you have to pay interest every single month.
The Problem with Mortgages
There is no need to re-hash all the problems that led to the housing collapse. But the most important thing to learn from that mess is that it’s ridiculous to buy more houses than you need. A mortgage may be “good” debt, but if it equals ten times your annual income, it will be nothing more than an anchor around your neck. An affordable house will generally cost no more than three times your salary. And even though “no-money-down” mortgages have thankfully gone the way of the dodo, it’s still important to remember that having a reasonable down payment saved is part of the process of home-buying. Not only does it give you instant equity in your house, but it also trains you to budget and to save money before you’ve even found your dream home.
Debt can be an important tool in your personal finance toolkit, but even good debt can lead to financial ruin. There’s the problem of using it incorrectly too. After all, just as a hammer can be incredibly destructive if incorrectly used, debt can be misused and abused – to devastating results.
While we are talking about issues with debt, let’s change the subject a bit and make sure you are avoiding these costly mistakes with debt.
1. Using your 401(k) to pay off a loan
There are a number of reasons why this is a bad idea. First, any money you take from your 401(k) prior to reaching age 59½ will be hit with a 10% early withdrawal penalty, as well as income tax. In addition, the money you take from your 401(k) will be considered earned income, which means that you’ll likely be pushed into a higher tax bracket when you make your withdrawal.
And all that’s before you even get to the lost growth on your retirement fund. Every dollar you take from your 401(k) is a dollar that can no longer earn compound interest.
No matter how big of a fix you’re in debt-wise, tapping your 401(k) should absolutely be a last resort.
2. Co-signing a loan to help out a friend or family member
It seems like a generous thing to do: you sign off on a loan for a struggling friend while they get back on their feet. But the thing is, banks require co-signers for people who couldn’t otherwise qualify on their own credit.
The bank knows that these individuals are bad credit risks — so you should recognize that truth, as well. Unless you’re able and willing to pay the entire loan yourself, and you don’t mind having a strained relationship (at best) with the borrower, then just say no to co-signing.
3. Signing up for a store credit card
The lenders behind store credit cards have your number. They know a discount and zero-percent interest window will seduce you into signing up for a card you neither need nor want.
But unless you can go straight home and immediately pay off the amount you’ve charged on the card, you’re likely to get stuck with a ridiculously high interest rate when the zero percent window closes. The cost in interest, which is often as high as 22% on these types of cards, far outweighs the discount you received for signing up.
4. Taking a payday loan
These loans are cancerous: they tend to grow and grow until they destroy your life. Taking a payday loan to survive until your next paycheck may seem like a simple solution – but if you don’t have the cash this week to pay for your unexpected expense, what makes you think next week will be better?
Instead of going to a payday lender, see if you can generate the needed cash by selling something, taking on extra work, or borrowing from a friend. And then start building an emergency fund, so you don’t find yourself in this position again.
5. Not having a credit card
If you struggle with credit, it may seem smarter to simply live without a credit card. Then you know there’s no way for you to get in over your head.
While those individuals who really can’t trust themselves with credit cards probably ought to live without one, it’s important to remember that lenders need to see that you can responsibly handle credit. If you ever want to buy a house or a car, it will be much more difficult to qualify for a good loan if your credit history doesn’t include responsible credit card use.
That doesn’t mean you shouldn’t be smart about your credit card use. Sign up for a card with no annual fees, and use it to make regular, automatic purchases, such as your utility bill. If you know you can’t trust yourself with the card itself, then freeze the card in a block of ice, and pay off your monthly automatic purchases to build your credit without tempting yourself.
The Bottom Line
Americans have been seduced by credit and instant gratification. Having everything available on credit, including expenses that people traditionally saved for like education and houses, made it seem like there was no limit to “good” debt. But student loans and mortgages are only as good as their borrower’s budgeting skills. Before jumping into a loan, know ahead of time what it’s really going to cost you.
Remember also that using debt responsibly is a skill you can learn. This is true even if you’ve made big mistakes in the past. Avoiding these five bad decisions I listed will get you on the right path.
{ read the comments below or add one }
Great comments everyone- I think “good” in terms of debt is a….relative term. No debt is good- but if you’re going to go into debt, something like a home or education that could yield security and returns is something that might be going into debt for. Of course, if you’re buying a house you can’t afford or likewise, a degree from a university you can’t afford when there are cheaper options- that’s stupid.
I know I’m one who is freaking out about the prospect of funding my second year of grad school with loans- sure, no debt is “good,” but if I feel it’s somewhat of an investment and I’m not spending those dollars on shoes and Tiffany (oh gawd but I’d love to) I’m trying to make myself feel less overwhelmed by it by justifying it as “less bad.”
Agree that there is some debt that should always be avoided. In fact, I think that if the only way you can buy something (e.g. holiday, car) is to take on credit card or personal loan debt, then you shouldn’t make that purchase.
But debt is certainly not always “bad”.
Problem is that most people do not have a sensible way of looking at the debt decision and find it convenient to label debt, often inappropriately IMHO, as “good” or “bad”.
The only reason I think there’s no such thing as “good debt” is because in every one of those situations, you could avoid debt by being more financially savvy. You can go to school without student loans. You can buy a house without a mortgage. You can get a car without financing it. Our problem is our impatience. It takes a while to change though. -BF
Well, I have lots of good debt.
Those student loans that paid for my MBA are costing me about 2-3% per year on the interest plus I can write off the interest. Meanwhile the MBA more than double my salary. Trend that forward 30 years with only 3% annual increases and see whether those loans are good debt.
My mortgage I re-financed at 2.375% for 30 years? That’s the cheapest $ you’re ever going to find, especially after you write off the interest on your taxes. Works out to be about 1.8%.
Now, if I could only find some rental property to buy and get even more leverage.
There is such a thing as good debt. Call me contrarian, but the time to take it on is now while interest rates remain at historic lows. Fed policy will not stay this way forever. When it stops, you’ll be happy you locked into as much cheap money as you could.
I think the rule of thumb “3 times your salary” or “2 times your salary” is a recipe for disaster. That’s what you will qualify for, given a decent credit score, however it’s hardly a wise thing to do.
My rule of thumb while home shopping was 1.5 times your salary, but preferred it at 1.25 times your salary. And this is with interest rates near 3.75. I could hardly understand how one can consider “affording” a mortgage at 6%, and 2 times a salary. That is nowhere close to being in a sustainable financial situation, and is merely a paycheck or two away from disaster.
It seems like of ironic to even have a term like “good debt”. I’m all for getting an education and living on your own. If you have to incur debt to get there that is fine, just don’t think of it as “good”.
I think resonable/afordable mortage debt or student loan debt is better than other debt, but not “good”. You can’t have wealth until you get rid of debt. People should try to avoid debt at all cost. Debt = risk. For example, parents should do their best to save up money and cash flow some of their student’s education, students should work part time, go to a more affordable school and consider the cost of living where you choose to go to school, defer for a couple years to work, etc. For mortgages, get the cheapest house that meets your needs and at a minimum do 20% down (PMI is a waste of money). In some areas it really is possible to pay cash for a house…you just have to wait longer. Work a second job or whatever it takes. Cut expenses like driving a car until it dies and living with parents or with cheap rent.
With any debt, you are paying interest. With student loans, you can only write off a small amount, and that really isn’t saving you much money. You just save the taxes. Luckily it is one of the few deductions you can take without itemizing (unlike mortgages). The average student nowadays is graduating with $27k in student loans and $5k in credit cards.
Sadly, too many are graduating with much much more…such as payments which they can’t even make because they are unemployed or their salary is too low. The private student loan companies used to not even consider how much the student was going to make after college. Thats why only 50% of student loans are actively being paid.
You can have a high credit score without debt….it just takes more time. To give me a head start I got a low interest car loan with a co-signer but paid it in full after a year. With paying credit card balances in full each month (staying within a budget and only spending money I have at the moment), I’ve still built great credit.
Something hardly anyone ever mentions is that you can get a mortage without a credit score. After you haven’t used credit for a period of time (18 or 24 months?), your score goes to zero. Even with the new rules, you can still qualify…you just have to have 20% down, job/income history, etc. I personally wouldn’t want to do that because I think credit cards are almost required in our society now due to safety and stuff (and some places are starting to only taking cards). And the fact that landlords, employers, etc, look at it.
Otherwise, you are stuck in the route of having to use your credit and keep you score up. FICO is really dumb because its only based on your ability to pay off debt (and more recently, ensuring you haven’t been late or missed rent payments)…they should base it on more stuff that is actually illustrative of you financial responsibility.
One of the key considerations when considering debt should be the return on your investment (ROI) – both financial and non-financial. For example, investing in an Ivy League college degree and pursuing a relatively low paying career just doesn’t make sense – UNLESS – you’re really passionate about that career so the spiritual aspects outweigh the financial. Still, you might be better off considering a cheaper college and less debt as the marginal return on the Ivy degree relative to your state university might not be significant.
I do not think there is any such thing as debt that is “all good,” so, conversely, I also think there is some debt that is not all bad.
My reasoning for thinking that no debt is all good is that all debt will require that you take some present day reources to pay for past spending. In other words, some of your income is already spoken for.
Student loans can be an example an example of debt that is not all bad.
Mortgage loans are not the same category of debt unless you end up underwater and even then you are getting value in the form of imputed income every month; that imputed income being the value of the housing you are receiving:
Remember, a mortgage loan is not the same thing as rent; it is the cost of acquiring the underlying asset — you get to live in the house for free. And it is often the case that when someone compares the cost of renting to the cost of housing, they overlook the value of imputed income in the calculation.
I agree that virtually all debt is “bad”. The only possible exception might be when you borrow money to get a guaranteed return on your investment (such as an education, etc.).
With that said, just because debt is “bad” doesn’t mean you can’t use it responsibly (a relative term).
Great post. Just an additional thought on Student Loans- because we are a society of instant gratification, most young adults feel that they should have everything their parent have right now. We forget that at one time our parents didn’t have the big screen TV, or a new cars. When my father went to medical school, both he and my mom worked, they lived in a dump and shopped garage sales for Christmas. The reason: to borrow the least amount possible as to lower the debt they had when he graduated. Fast forward 20 years, and you have myself who hadn’t learned that I needed to wait for the finer things in life. I took out the maximum amount FASFA would allow so I could have everything I wanted. Now I have $36,000 in Studen Loan debt, when in all reality I should only have around $10,000. I am hitting my head against the wall telling myself how dumb I was.
As much as I agree with what you’ve written, I can see why some people feel as if they cannot put off college and feel that student loans are their only choice. In the time I was an undergrad, tuition, fees and parking permits went up every semester by a few hundred dollars.
For some schools, trying to get a job with just a high school diploma (or even a bachelor’s degree) is difficult, but even more so- to save money for a moving target- the rising cost of tuition. Additionally, applying for certain schools requires “striking while the iron is hot” in terms of getting letters of recommendation, credits that are still transferable before they expire and being in a certain age frame to qualify for scholarships. Of course, getting a student loan isn’t ideal- and goverment student aid (also getting more restrictive) might be easier when you’re older/more independent- but it could also be harder to qualify for certain scholarships/aid when you make more, have more saved or are older.
Great points- but I just wanted to put in my two cents since it’s something I’ve struggled with tremendously as a grad student. Should I have waited to apply when I had more money, or do I risk a myriad of factors I can’t predict that could prevent my entrance?
There are no easy answers I suppose- but your post gives us something to think about.
If managed in the correct way, they can of course be good debt which will help you out no end. Credit cards for example won’t inccur any interest if you pay off the debt at the end of every month.
I agree with you except in one instance. Few people early in their working career can afford to pay cash for a house. I personally feel the only good mortgage debt is a 15 year mortgage where a purchaser puts down at least 20% of the debt at settlement. That is what I did a long time ago. Today, I am retired and have no debts. I agree an older retired person should never have any kind of mortgage.
I agree that it’s all relative. Student loan is not good especially nowadays because your return on investment is not guaranteed. But on the other hand, can you afford NOT being educated? While the recession hit college grads hard, it hit non-college grads even harder. The key is to know what you’re getting yourself into and being able to at least guestimate how much you can afford when you’re choosing a school and taking out a loan.
Debt is not intrinsically “good” or “bad”.
It should be viewed as a mechanism for bringing forward expected future cash flow. If you can use the money more effectively now than you could by waiting until it is actually received, then it may make sense to borrow.
In fact, borrowing can be a very effective way to spread investment risk over time, rather than only investing when cash is available. Used this way, it can actually reduce risk.
So for many people in their twenties and early thirties, with good earnings prospects, a carefully structured borrowing program allowing them to make regular investments in the stock market over an extended period may prove a more prudent strategy than delaying investment until savings become available.
John, great comment, well stated, and articulate. It is obvious that you have given the issue considerable thought and few people actually think it through like that.
I am of the opinion that there is some kinds of debt that are intrinsically “bad,” however. Credit card debt that piled up for discretionary expenses, for example.
Taking on carefully considered strategic debt when you are young…solid concept but not often actually executed in the real world because it is an advanced personal financial management strategy and most people in their twenties do not even get the basics right But a solid concept in theory.
However, using debt to preserve liquidity, as you mention, is another sound concept. I have a mortgage on my primary residence with a balance of $70,000 that I could pay off at any time but I prefer to retain a more liquid position.