When it comes to debt, the ideal situation for most of us is to be free of it. But again, for most of us, having some debt is a necessary evil. One key to managing debt and keeping it under control is to understand the different kinds of debt and the effects of each on our financial health.
Since most of us who want to own a house can’t afford to pay for it in cash, a mortgage is a necessity. This can be considered good debt since we are purchasing an asset that over time should appreciate (notice I said over time and should). Furthermore, we are purchasing an asset by only using a relatively small portion of our capital. Again, a good use of debt. Finally, under current tax law the ability to deduct the interest on the mortgage makes it attractive.
Other types of good debt can include a small business loan to start a business or borrowing to expand a business. The reason this is good debt is that you are using the money to hopefully make money.
But even good debt used in excess or unwisely can become ugly. So, don’t buy too much home and do your homework before investing in a business.
I categorize bad debt as debt that is often necessary, but lacks some of the characteristics of good debt. For example, most people find it impossible to pay for a car with cash. Most need a car loan. This is bad debt because you are putting your money into something that will depreciate and the interest is not tax deductible. The key with bad debt is to limit its use. Keep your car payments low and don’t let the dealerships convince you to buy more car than you need. And for goodness sakes, don’t pay for a car for more than five years. If the only way you can make a payment on a car is by stretching the loan for more than five years, you can’t afford it.
Ugly debt is just about everything else. The most obvious culprit is credit card debt. It still amazes me to find very bright individuals with $10,000 in a savings account earning 0.05% and $5000 on a credit card with an 8.99% interest rate. This is insane; not to mention the cards and loans with 14%, 21%, or even higher interest rates. Now, in today’s society we need credit cards. My recommendation is to have two. Have one you use regularly and pay off the entire balance monthly. Find one that preferably gives you cash back. Have a second card for true emergencies, not for normal spending.
So where does that leave student loans? On one hand, they are good debt because it is an investment in the education of the student that should pay off in the future. Also, the rates are normally fairly low. On the other hand, this too can become ugly. I recently came across someone who accumulated $180,000 of student loan debt, but never completed the degree so will not earn the projected income.
The lesson with all debt: be careful to not get in over your head.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual.
With all this talk about the failure of the “Super Committee” to reach agreement on deficit reduction, I have a few random thoughts and questions…
- It was fairly obvious from the beginning that the members selected were very partisan ones. Did anyone really expect them to come up with anything?
- How come not one member selected for the committee was up for reelection in 2012? Would that have provided a sense of urgency? Maybe all should have been up for election.
- Why do all the politicians and the media keep saying that these are cuts, which implies the budget will be smaller, when the reality is these are nothing more than cuts in the rate of growth? The budget will still grow, just by not as much. How austere is that?
- Mostly lost in all of this is the realization that we have finally shifted the conversation to both political parties discussing shrinking the size of government. The size of government spending as a percentage of Gross Domestic Product while way too high has leveled off. Is there some room for optimism here?
- Finally, why do investors fret over this partisan bickering? Yes, the size of our debt is important. The fact that we spend 40% more than we take in is unsustainable. But this committee wasn’t going to change all of that. In the end it will take a change in the mindset of Washington and that, my friends, is when you and I get to have our say come next November. In the meantime, don’t let the frenzied investment press get you overly worked up. Stay diversified, stick to your plan, but remain flexible since we do live in an uncertain economic time.
Hold on to your kryptonite.
*The opinions in this material are for general information only and are not intended to provide specific advice or recommendation for any individual.