I’m practiced in the art of using debt. Like most things, debt in moderation can be good—it opens doors to opportunity. Overuse ruins lives. The consequences of having borrowed money can slam those same doors shut. How do you walk this line? You’ve heard about good debt and bad debt. Rules of thumb like these are useful to make the world understandable and complex decisions easier. Let’s start with the rules of thumb, then personalize them to apply to your circumstances.

Bad debt

Good debt

Credit cards
Auto loans
Personal loans
RV, boat and airplane loans
Second mortgages/home equity lines of credit
Mortgage (other than primary residence)
Payday and pawn shop loans

Mortgage (primary home)
Student loans (federal and private)

More bad than good

You noticed, right? Most types of borrowing show up, at least initially, on the right side of the chart. Point well taken—if we generalize, debt is not a good thing. What, then, might move a debt to the good side for you?

Let’s define some ground rules for good debt:

1. The interest rate is low and fixed.

2. Interest paid is tax deductible.

3. After taking all expenses in to consideration, you are better off (financially and/or life experience-wise) for having taken on the debt.

If you have overspending issues, you should apply these ground rules strictly to improve your financial situation. When it comes to rule #3, a debt has to meet both tests—it will both improve your life and put you in better financial position. That’s a high bar!

What does bad debt look like?

1. The interest rates are high and variable, making it difficult to whittle down balances.

2. It is used to make discretionary purchases you can’t afford.

Some debt won’t fall neatly into either category. For these shades of gray, you’ll need to make a judgement call based on your own situation.

Making it personal

To categorize debt as good, bad, or somewhere in-between, carefully consider both the opportunity and the consequences. Let’s walk through the categories together:

Mortgage debt: Mortgages are the epitome of good debt—they meet all three criteria:

1. Fixed mortgage interest rates are still close to historic lows. Just say no to an adjustable rate mortgage loan, even if the initial rate is lower than a fixed rate loan. Interest rates are more likely to rise than fall. When your adjustable rate goes up, you won’t be able to refinance at a fixed rate comparable to those offered today. Take the fixed rate mortgage and sleep easy knowing that your mortgage payment amount isn’t going to change!

2. Though there are now some limits, mortgage interest is generally deductible on your income tax return. If it is, your effective interest expense, after factoring in what you’ve saved on income taxes, is even lower than the stated mortgage interest rate. However, you have to be able to itemize deductions to take advantage of this tax benefit. After the Tax Cuts and Jobs Act (TCJA) came in to effect in 2018, only about 10% of Americans can still itemize deductions, down from 30% prior to TCJA. If you’re in that 10%, enjoy the benefit of tax deductibility!

3. If home ownership is your goal, using a mortgage to finance the purchase can make it possible. Your desire to own your own home speaks to the life experience improvement. Two factors make home ownership, and the accompanying mortgage, attractive financially:

• Homes generally appreciate over time, and

• Home ownership may cost less than renting.

You may want to pay your mortgage off before retirement to reduce your monthly expenses, but otherwise there isn’t a rush to get rid of mortgage debt. For most people, this is the kind of good debt we can live with.

Student loan debt: We borrow for education because we expect it to lead to better opportunities. Interest rates are usually reasonable. Most taxpayers can deduct student loan interest without having to itemize deductions. Our three criteria for good debt are satisfied! But be careful here! As a nation, we borrow more for education than we can easily repay…which sounds like bad debt. As a community college administrator, I saw students borrow thousands of dollars for degrees that led to very low paying jobs. (Don’t even get me started on the logic of offering college degrees that lead to non-living wage jobs…). Others borrowed but never completed a degree at all.  From a financial perspective, these weren’t good investments. However, if your education allows you to do something you truly love and consider your life’s work, then the life experience boost may trump the financial cost. Your prospects, in additional to the amount of debt and its interest rate, all need to considered for you to decide if student loan debt is good for you.

Credit card debt: Credit cards have so many different options today, they do everything but the dishes. But they still carry stiff interest rates if balances aren’t paid off each month.

• If you aren’t prone to overspending, you can use credit cards for purchases to get cash back and earn rewards. Then pay the balances in full every month. This isn’t debt and there is no interest.

• If you are carrying a balance from month to month, it’s debt, and it’s likely the bad kind, even ugly. If you’re using a no fee, zero percent interest offer on a credit card and it’ll be paid off without problem, that’s debt, but not bad debt. If you used that offer to pay down other higher interest rate debt, it’s even useful debt.

• Running a balance and paying interest because you bought things that you can’t afford right now is bad debt.

There’s some wiggle room between the two extremes. Be honest with yourself about where you are.

Auto loans: In a perfect world, we would save and buy cars with cash. In the US, more than 80% of new cars are financed. We borrow to buy new cars even while knowing that they won’t be worth what we owe when we drive off of the lot (this is the definition of being upside down on a loan). If a car is a necessity—to get to work, for example—and you don’t have cash, you can minimize how bad your auto loan is:

• Keep your purchase modest and inexpensive to maintain—you don’t need a Corvette to get to work. Scour the reviews to make sure that the car you’re buying is going to be reliable. I don’t care how reliable the Ferrari is, if you need to finance the purchase you can’t afford the maintenance.

• Get the lowest interest rate possible—shop for the best financing offer. Consider tapping your credit union for an affordable interest rate.

• Buy used—a lot of the depreciation has already occurred and the prices are lower.

• Maintain it and drive it until the wheels fall off. During your current car’s life, set up automatic monthly savings deposits to build up your next car purchase fund.

Personal loans: Credit unions and banks offer personal loans to borrowers with good credit. Unlike a mortgage or auto loan, these loans are not secured by a physical asset. The lender is relying on your ability and willingness to make payments. Because this is a risk for the lender, you’ll pay a higher interest rate than you would for a mortgage or secured loan. However, the interest rates are typically substantially lower than those on credit cards. The lowest interest rates go to borrowers with the highest credit (FICO) scores.

RV/boat/airplane debt: If you’re living in it, you could call it a necessity, and maybe it’s good debt. Even so, you don’t get the other benefits of home mortgage debt—attractive interest rates and potential income tax deductions. And if these are really toys, this isn’t good debt.

Even though traditional financial planning wisdom says that you should save and wait to make a luxury purchase instead of borrowing, that’s not what we did to buy our boat. We bought Phoebe Alice with a loan several years before we left NYC. Though she was only 31 feet, we had never sailed a boat her size. We chose to pay more (purchase price plus interest over a couple of years instead of purchase price alone) so that we could have the boat during those couple of years to learn to sail her. It also gave us time to get her equipped for long distance sailing and to become our floating home. She was paid for and equipped before we took off and we had experience sailing her. Was this good debt? No, but it wasn’t bad debt either—it was useful. We paid more to have the boat sooner and never regretted it. What are your personal decision factors?

Home equity debt: A second mortgage or home equity line of credit (HELOC) can be used to make improvements to the home, in which case the interest expense is deductible within limits, just like a primary mortgage. Since TCJA, however, interest on a second mortgage or HELOC that isn’t used to make improvements isn’t deductible, even with the other limitations imposed (that you have to be able to itemize and the limit). A HELOC can be used to supplement your curveball fund when unexpected expenses crop up. This should be kept in tight bounds—you don’t want to lose your home because you’ve borrowed on your HELOC to cover living expenses after losing your job. Good or bad—depends on you and the specific circumstances.

Second home/vacation home mortgage debt: Now we’re veering into the luxury territory. While mortgage interest rates may be attractive, interest deductibility isn’t guaranteed. TCJA introduced new limits on the total amount of mortgage debt interest you can deduct, if you are in the 10% of taxpayers who still itemize deductions anyway. Few people can make the case that a second home is a necessity. Debt for a luxury shouldn’t go in the good debt column, even if it satisfies the first two good debt criteria.

We ventured into second home ownership a few years ago. Mortgage rates were low and real estate prices continued to be depressed in the Blue Ridge Mountains, where we hoped to relocate. We decided to go ahead and buy a second home in the area where we would move “in a couple of years”. Then life took a turn and we moved my dad to North Carolina so we could take care of him. The move to the second home had to be pushed off.  Much as I love the place, our lives would be much easier today without a second home. What started off as useful debt is now edging in to the bad column.

Payday and pawn shop loans: Use of either of these is the red flag of financial distress. The Federal Trade Commission can guide you in Choosing a Credit Counselor. Get started today!

Understanding the role debt plays in your life can help you make better decisions. Need a second opinion? Give me a call at (336) 701-2612. 

Investment advisor representative of and investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Fair Winds Financial Advice may offer investment advisory services in the State of North Carolina and in other jurisdictions where exempted.