Most of us have heard personal financial advisors divide debt into two broad categories: “good debt” and “bad debt”. In this framework, “bad debt” represents that debt which is incurred to finance short-term consumption while “good debt” is used to purchase assets or increase earning capacity. In reality, this division is overly simplistic and may even be harmful.
Consumer debt, incurred to finance consumption, clearly has long-term negative impacts. Making purchases today with the hopes of being able to pay it off tomorrow encourages poor purchases and decreases future earnings by replacing investment returns with an interest burden.
But what about “good debt”? Doesn’t it make sense to incur debt for housing, education, and autos? Maybe. But the answer isn’t unambiguously affirmative, and by convincing ourselves that debt we incur in these areas we may unintentionally damage our financial futures.
In this special 3-part series, we’ll look at each in turn.
Housing:
Let me lay out a few arguments we often use to support mortgage debt:
- Buying a house is a great investment. Prices are bound to go up, maybe as much as 10% per year.
- Mortgage debt is a great tax shelter.
- You should buy as much house as you can afford. This will enable you to earn more when you sell it.
The current housing crisis clearly points out the fallacy of this line of thinking. Housing prices have traditionally increased at roughly the rate of inflation, or about 3.5% per year. While this can add up over time, especially with leverage, it doesn’t make housing a slam-dunk investment. Many people buying into this line of thinking bought much more house than they could afford. Recent studies by the US Census show that 38% of mortgage holders pay more than 30% of their income in mortgage payments, the level at which the US Government considers housing expenses an unreasonable burden. And 15% of mortgage holders pay more than 50% of income to mortgage payments. Even without declines in housing prices, these borrowers would be in trouble.
To avoid falling into this trap, think of housing as you would any other expense: buy what you can afford, using standard banking ratios of 28% of income as a good guideline for the maximum monthly payment. You will have adequate housing, while still being able to afford other financial goals such as saving for retirement, education expenses, etc.
Check out our other posts in this series to learn why student debt or auto loans may do you more harm than good.
Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs. DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.
