The Good, the Bad and the Ugly

Even though we’re surrounded by debt in our day-to-day lives, it’s not all created equal. We can leverage debt to our benefit, but it can also get away from us if we’re not careful. And the more debt we carry the less likely we are to be financially successful over the long-term. So, it pays to understand that there are three kinds of debt: The Good, the Bad and the Ugly.

The Good - Yes, there is such a thing as good debt. To be considered “good”, the debt should have been used to purchase something of long-term value (like a home, perhaps a car), have a fixed interest rate and a straightforward repayment plan.

A 30yr mortgage on your primary residence is a perfect example. If your credit score is good and you have a decent job you should be able to borrow at a reasonable interest rate. Your property taxes and home insurance would likely rise over time, but your monthly principal and interest payments would be fixed, based on a set schedule. This creates certainty in an often otherwise uncertain financial world.

Since what you’re buying is a tangible item that could be reclaimed by the lender if you default, interest rates are comparatively low. The average 30yr mortgage rate is 4.2% currently. If we think about the longer-term inflation rate being 2+% and interest rates rising in the future, the cost of your loan today could become cheaper purely from the passage of time. This is the opposite of an adjustable-rate loan in a rising rate environment, but we’ll get to that next.

Refinanced student loans can also fall into this “good debt” category if they have fixed terms and helped you to get into your current career. As a bonus, interest on good debts like home mortgages and student loans can be tax deductible, which helps with affordability.

The Bad - Debt is considered “bad” when it didn’t help you buy something of lasting value and if it doesn’t come with a fixed rate and straightforward repayment schedule. This means anything “adjustable”, such as interest rates that can change (we’re mostly concerned with them going up from current low levels) over time.

While not being the end of the world, adjustable-rate debt adds uncertainty, can increase anxiety, and can accelerate catastrophic failure in more extreme cases (such as during the Financial Crisis). Since there is added risk with this kind of debt it should be used cautiously. Say someone was looking to buy a home and they were very sure they’d only own it for five years. Maybe they could borrow at a reduced “teaser” interest rate for those first five years and then sell the home before a higher interest rate kicked in. Worse case, they’d be stuck with a more expense loan in the future when the loan resets. Maybe they could refinance or sell and come out ahead, but neither is guaranteed. Best case, they feel like a financial wiz for beating the banks at their own game.

The Ugly - Ugly debt is creative, interesting, and lets you do things you wouldn’t otherwise be able to do on your own. That doesn’t sound so bad, right? Well, it is, because it’s expensive and risky, which is not a good combination.

Take interest-only mortgages for example. These can let you buy more house than you can afford because the bank lets you pay just the interest on your mortgage, say for ten years, while your principal remains untouched. The surprise comes later when the lender requires higher payments during the last 20 years of your loan to compensate. A whacky variation of this is the negatively amortized loan, where the borrower pays less than the interest owed while the remaining amount gets added to the loan balance.

Credit cards, and consumer debt in general, is pretty ugly. It could be a low promotional rate on a credit card balance transfer that jumps to 30% if you can’t pay off your balance in time. Maybe it’s old medical or dental bills, or that hot tub you bought last year. These kinds of loans are risky to the lender because they can’t repossess anything if you default, so the interest rates are high.

The ugliest of ugly is the payday loan or auto title loan, where you borrow an advance on your future paycheck or on the value of your used car. Interest rates and fees in this area are the worst you’ll see and can really make the borrower feel like they’ve fallen into quicksand.

Natural Conclusions - Pay off debts in reverse order, starting with the ugliest debt you have. Ultimately and hopefully you’ll find yourself with no debts other than a fixed-rate mortgage. This debt is fine to carry for the long term assuming your interest rate is, say, below 5% and your other savings and investments are earning more than this, on average. All higher-cost debt has got to go.

Beyond that, and at the risk of sounding like the stodgy financial person, don’t make a habit of buying things you can’t afford just because someone is willing to lend you the money. Borrow to buy things of lasting value that materially add to your wellbeing (and your bottom line). These are investments you make in yourself and I don’t think the latest and greatest tech gadget or fancy new car qualifies.

Have questions? Ask me. I can help.