(Financial Check-Up - Part 3)

No, this isn’t a review of an old Clint Eastwood flick – this really is a financial planning column.  In fact, this is Part 3 of our Financial Check-Up.

Debt – well, debt is not a sexy topic, is it?  When I raise the subject of debt with my clients, too often they express a sense of guilt or shame that they owe money, that they have not been as good with their money as they think they “should” have been.  While I DO want my clients to be free of debt, let’s be clear on one thing:  some types of debt are defensible, perhaps even desirable.  So let’s dispense with that guilt complex – instead, let’s have a mature, all-too-rare chat about debt, as free as possible from shame or headline horror stories.

Today, we’ll look at “good” debt and “bad” debt and what distinguishes them; in the next installment we’ll discuss “ugly” debt and strategies for getting out of debt.

Good Debt

For at least a moment, forget what those television gurus tell you about paying off your mortgage.  They are not necessarily addressing your specific situation – and it is blatantly misleading to pass off such advice as applicable to all.

The simple truth is that most of us could not be purchasing our homes but for the availability of “cheap” mortgages.  And even if you can pay cash for your home, I might still suggest that you consider other ways to use your money – for instance, it is wiser to fully fund your retirement than to pay off your mortgage.

Why might it be best for you to carry mortgage debt?  There are three primary reasons: 

1.The use of borrowed money, or leverage, allows one to purchase much more home than would be possible if paying with cash – which, in turn, means that one will benefit that much more from appreciation of the property over time (assuming 5% annual appreciation, calculate how much a $100,000 home will be worth in 10 years, and then make the same calculation on a $200,000 home).  This remains a sensible strategy, even after the recent mortgage mistakes made by many.

2.Mortgage interest is fully tax-deductible for most middle-class Americans, reducing the after tax “cost” of debt by approximately one-third.

3.Mortgage debt is a hedge against inflation (and is better than gold in this respect because you can live in and revel in your house).  Paying a locked-in interest rate for 30 years, while inflation eats away at many other investments, is a vital benefit. 

Other “possible” kinds of good debt include loans for education (the debt increases future earnings), automobile debt, if one cannot possibly buy a car for cash (so long as one does not buy more car than one needs, even at 0% interest) and, in rarer circumstances, debt incurred for investment purposes (and never let your stockbroker talk you into borrowing for investment purposes unless you are convinced she has no conflict of interest in the transaction, which is pretty hard to prove).

Bad Debt

For this discussion, bad debt is that money you borrowed at unreasonable interest rates or where the interest is not tax deductible.  

For instance, even mortgage debt can be “bad” debt.   That would be when the interest rate on your mortgage is pretty much anything more than 1% higher than the rate you can now readily obtain (depending, of course, on how long you plan to stay in your house).  In this situation, you should consider refinancing immediately.  Demand a lower rate from your lender – if they balk, go somewhere else.  Money-lending is a competitive business and you should allow lenders to compete for your business.

Mortgage debt is also “bad” if your original debt-to-equity ratio is too high; for instance, if you borrow more than 80% of the purchase price or realistic market value, you are overleveraged. 

“Bad” debt generally also includes car loans (the longer the term, the worse the debt), boat loans, vacation house loans (interest is probably deductible, but you are also probably not using the house enough to be carrying debt on it) – anything involving the payment of interest that is neither tax deductible nor for “essentials”.  

But even “bad debt” is not necessarily “ugly debt” – and we’ll talk about ugly debt in the next appointment of our Financial Check-Up.

Next: Part 4 ~ Ugly Debt – and the Beginning of Financial Health