Is There Such a Thing as “Good Debt”?

Mortgage

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Kevin At Out of Your RutThis post is from a new FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.

In the world of personal finance we often hear the term “good debt” thrown around in discussions of debt or of debt payoffs. But is there really such a thing as good debt, or do we use the term as a backdoor justification to overextend ourselves to pay for things we really can’t afford?

Mortgages and student loans are regarded as good debt since they afford us the ability to increase our wealth and employment value in the world. Bad debt includes credit cards and consumer installment loans, and floating somewhere in the middle are auto loans—perhaps defined as good or bad based mostly by their size.

Why Good Debt may not be as good as we like to think

We have little trouble seeing the problems with bad debt, but let’s take a closer look at the debts we might call good.

Mortgages. The major positive aspect of mortgage debt is that it’s used to purchase shelter, which is a necessity. It’s also debt used to acquire what has been, at least until the past few years, an appreciating asset—a classic win-win.

But while the real estate/mortgage crisis of the past three years has been summarily dismissed as a temporary blip in a longer trend toward ever higher home values, it’s also exposed substantial weaknesses in the previously unassailable notion of mortgages as good debt. Consider the following:

  1. A mortgage is often a catalyst for other debt. Buying a home usually sets off a chain of spending in other directions—home furnishings, remodeling/rehabbing, a new car to go in the new driveway among them. Already cash strapped new homeowners commonly borrow to pay for these.
  2. The enormous size of mortgages in relation to income and to other debts can make early payoff seem impossible, fueling a pattern of perpetual debt.
  3. People often respond to rising home values and increasing equity by periodically borrowing much of it out, creating a debt treadmill.
  4. Because of the many virtues attached to owning a home, buyers are often tempted and encouraged to buy more house than they can afford. This is one of the major reasons for the mortgage meltdown.
  5. Low down payments cause buyers to over-rely on mortgage financing. In this way, future income has been fully and entirely committed to an extreme degree years before it’s even earned. The result is often a pattern of never getting out from under.

So is a mortgage a bad thing to have? No. And yes.

It can be good to have if you”¦

  • can make a down payment of at least 20% of the purchase price,
  • buy beneath your means—your house payment is no more than 20-25% of your stable monthly income,
  • have the desire and the means to pay off the loan in substantially less than the original term,
  • have some breathing room in both your monthly budget and bank account after closing, and
  • buy a house as a place to live long term, not as an investment to be flipped at an expected profit in five years or less.

A mortgage is a bad thing if it represents nearly the entire purchase price of the home, if it will leave you with an empty bank account, if it will consume so much of your income that you’ll have little money for anything else, if you have no ability or intention to pay it off early or if your primary reason for buying is for investment potential.

The fact that a house is a good thing to own, and that a mortgage is needed to buy it, should never mean that we abandon good sense in the process.

Student Loans. So much virtue is attached to a college education that debt incurred to attain it is often considered only in the most benign terms. Fueling this view is that fact that student loans carry repayment deferral, government guaranteed below market interest rates and impossibly small monthly payments. Student loans may be the “good-est” of good loans!

For that reason alone, red lights should be flashing while emergency sirens scream.

Even with a 4-5% interest rate and a monthly repayment equal to no more than 1% of the outstanding loan balance, repayment on a loan of $40,000, $50,000, or $100,000 is still prohibitive, both in the size and duration of the payments.

Imagine having a $50,000 loan with a $500 per month payment that you’ll have to pay for ten years or more? And you will pay it. A government backed student loan usually cannot be discharged in bankruptcy, and if you fail to pay, your resources—including income tax refunds—can be seized until the debt is satisfied.

You will be required to pay the loan at a time in your life when you will be on the low end of the income scale, when you may experience a slip or two on the way up the earning curve, when you may be considering marriage, children or a geographic move, and when you will be acquiring necessary life’s assets such as a home and car.

In my many years in the mortgage business, I can’t count the number of times I saw loan applications from people in their 20s and early 30s who had a financial profile that looked something like this:

A $10,000 car loan
$7500 in credit card debts
$50,000 in student loans
A $35,000 salary
A $3000 bank account

This person is carrying $67,500 in total debt on an income of just $35,000! Even if he had the potential to double his income to $70,000 in five years, that would still be an enormous debt load. But even by the time his income reaches that level, he’ll likely also have commensurately more debt. After all, he’s already applying for a mortgage! A wedding and children will only increase the pressure to borrow.

One of the biggest hidden land mines with student loans is the fact that they put the borrower in a deep debt hole early in life, which can set a pattern that follows throughout life and is difficult to overcome.

Good or bad, ultimately it’s all just debt

One of the problems with debt in general, is the perpetual nature of it. Any time we borrow money for any purpose, a dynamic process is set in motion. Once that process is in operation, reversing it to pursue a different course is considerably more difficult.

What ever label we chose to put on it, good, bad or in between, all debt shares the same characteristics:

  • it represents an obligation which must be paid back
  • it represents a lien on-, and therefore a reduction in-, our income
  • it lowers our net worth
  • it limits our mobility and constrains our options

When you consider these facts, do you truly believe there is such a thing as good debt?

Photo courtesy bluemodern

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{ 31 comments… read them below or add one }

Matt Jabs 2010/03/11 at 6:33 am

This is one personal finance blogger who you will never hear use the terms “good debt” in the popular meaning of the word. Debt = slavery… and I’ve never heard anyone use the term “good slavery.” 🙂
.-= Matt Jabs´s last blog ..Refinance Home Loans ““ How One Call Saved Us $41,123.16 =-.

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paul 2010/03/11 at 8:58 am

Indeed, being free is a blessing to itself. Mortgage I’m coming for you!

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thisisbeth 2010/03/11 at 7:17 am

People actually think they need a new car to put in their new driveway? My car is eight years old. Buying a house made me even more determined to keep that car running before a different used car is parked in my driveway (or garage, in my case).

I did got into a little debt after buying my house just with lots of little things between the house and other major life events. I do have enough money in the bank to pay it all off, but I decided I’d rather have money in the bank in case of emergency. When my tax refund comes, I will pay off a good portion of the credit card debt (while still saving half of the refund for future house repairs).

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paul 2010/03/11 at 8:57 am

Way to go Beth, live a life of freedom!

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kt 2010/03/11 at 7:20 am

the only thing that i would consider as good debt is money that i borrow to make more money. this is after a lot of research into things like the ROI etc. in my books student loans dont even remotely qualify for this category

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jon110334 2012/06/20 at 6:50 am

My wife took 15K in student loans to become an aerospace engineer. She now makes about 30K/year more than she would without the degree, that’s a 200%/ year ROI on that debt.

The problem with a lot of statistics is they unintentionally mis-represent the data. What you need to concern yourself with is medians, means, and ways to beat the mean… a lot of sources just provide the mean, which provides only a portion of the information you need. If you take an “mean” of her success with someone making 0% ROI on a 100K dollar loan, it greatly undermines the potential of student debt.

Think about a degree as a money tree… the type of degree often determines how much money it can grow a year. If it grows 10K/year, and you pay 1M dollars for it, that’s not a good investment. If you pay 10K for it, then it is. College CAN be a good investment, but like mortgages, there are ways to mess up.

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myfinancialobjectives 2010/03/11 at 8:01 am

Ah-Greed… I have slashed my living expenses, moved, and am pursing a second job. All to rid myself of the “Good Debt” aka student loans. The sooner I am debt free the better!
.-= myfinancialobjectives´s last blog ..The Ultimate Motivator: Compounding Interest =-.

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Joe Plemon 2010/03/11 at 9:08 am

Thanks for poking holes in the “good debt” mindset. Well done!

I’m with Matt. Some debt is worse than other debt, but that doesn’t make any of it good. “Good debt” is an oxymoron!
.-= Joe Plemon´s last blog ..Reverse Mortgages Part Three: What are the Disadvantages? =-.

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paul's wife 2010/03/11 at 10:11 am

Great article. I like the emphasis on student loans. I know a lot of people who are totally caught up in the idea that they are just a way of life. I’m thankful I only had one very small loan after college ($2500 – $50/mo). It was paid off quickly. Your snapshot of the typical loan applicant is very telling of how quickly a family can get in over their heads in debt.

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Kristine 2010/03/11 at 12:48 pm

What would happen if physicians didn’t go to medical school because they didn’t want to incur debt? What if it’s their dream to be a doctor and help people, but they’re afraid of getting into debt?

School loans can help people achieve their goals. It can help you produce more value. Now, if you go into debt just to consume, that’s another story.

People fear the word “debt.” But, if you develop a plan and have a way to pay it back, then that’s using debt to your advantage. Debt also allows you to leverage other people’s money, or OPM. What if you could borrow money at one rate, and invest it in something with a higher rate?

Call it good, or bad, or whatever you want. It’s how you use it that makes a difference.
.-= Kristine´s last blog ..Financial Freedom Resources – Tools to Help You Maximize the Assets Around You =-.

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Ryan 2010/03/11 at 2:57 pm

I agree with the general notion that debt is bad, but I think it really just requires a deeper understanding of finances and economics. For most people, I wouldn’t recommend any debt except for student loans like you mentioned. Most people don’t realize that they would be better off renting a small apartment until they have a hefty savings account than they would be buying a house with no savings at all. The potential for appreciation isn’t worth the risk plus you’re paying lots of taxes and interest.

In the end, debt is a risk to take and must be approached wisely. If you’re taking the risk for the right reason then it may be worth it, but if you’re just doing it because you see everyone else doing it then it will likely put you in the slave position.
.-= Ryan´s last blog ..No Cash! How to Pay Via Text with Venmo =-.

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Kevin@OutOfYourRut 2010/03/11 at 3:08 pm

thisisbeth–the new car thing is actually true. Statistically, the typical home buyer buys a new car 9 months after buying the house.

myfinancialobjectives – “Good debt” is only good debt when we’re initially getting the thing that it buys. After that it’s just…debt.

Joe Plemon – “Some debt is worse than other debt”–classifying it in degrees of negatives! WELL PUT! You’re so right, good debt is an oxymoron, but you won’t ever hear that from the purveyors of that debt.

Paul’s wife – I wish that sample profile were a fiction but it isn’t. The worst part is when you look into the eyes of these young people and see the hope the have. But hope doesn’t get debts paid, especially when they’re well into five figures (or even six!). I think that once we come to view high debt levels as normal, we’re sunk. That really was the problem that drove the mortgage meltdown. It takes courage to buck prevailing trends, and few people seem to have it.

Kristine – Doctors would be one of the few exceptions on student loans because of the high compensation they can expect, ***important*** even if they aren’t outstanding at what they do. It’s a high percentage career field, but the number of those is dwindling. In many fields a college degree is no longer even a guarantee of employment let alone of career success. I’m not saying a degree isn’t important, only that it may no longer be worth plunging deep into debt for. In today’s world, marketing skills, money management skills and entrepreneurial skills are at least as important as a degree. I’d rather have all of those skills and no degree than have a degree without them.

I appologize to all for posting, then disappearing for the day, but it was one of those days. Thanks Paul for inviting me to post, and to all of you for reading and for commenting!
.-= Kevin@OutOfYourRut´s last blog ..Why It Might Be Better to OWE on Your State Income Tax Return =-.

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myfinancialobjectives 2010/03/13 at 6:58 am

Interesting point Kevin! So are you implying that while I was in school my student loans were “good debt”, but since I am not in school anymore, it’s just debt?

I would have to say that I will for the rest of my life be using the item that my debt purchased, my education. I am not in undergraduate school right now, but due to it I have my job and my income, therefore I am technically still “using” the item that my debt purchased?
.-= myfinancialobjectives´s last blog ..The Ultimate Motivator: Compounding Interest =-.

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Kevin@OutOfYourRut 2010/03/11 at 3:14 pm

Ryan – I agree that student loans can buy a nice advantage with a degree, but I would also add that there has to be a limit on how much anyone should borrow in order to do it. When we’re young and beginning a new venture, we’re bubbling with optimism about our prospects, but prospects have limits in the real world. It’s akin to starting a new business, then getting hit with that dose of ice cold water six months in when we find that pay dirt is a good bit farther out than we planned or budgeted for.

Good point on housing as well. That was another type of borrower I saw frequently, and perhaps the most puzzling. Why a person coming fresh out of college, a divorce or a career transition would want to buy a house right away seems to defy logic. It always seemed to me that if you’re in a time of transition it’s super important to keep your options open. But then I’ve never claimed to be an expert on human motivation!
.-= Kevin@OutOfYourRut´s last blog ..Why It Might Be Better to OWE on Your State Income Tax Return =-.

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Eric J. Nisall 2010/03/11 at 7:08 pm

I’m not going to lie, I’ve never been a supporter of a cash-only lifestyle. I view it to be lacking in many ways such as security (ie: if you lose cash, there’s no way of getting it back or purchase protection in the way that Jim Wang at Bargaineering spoke of yesterday) or flexibility. Still, I will never shoot anyone down for believing in something that I don’t. Those things being said, I have wrote time and time again on my own blog that credit is a tool. Anyone can go out and buy a power saw to assist in the building process, or get behind the wheel of a car to get someplace in a timely manner. However, if you have no ability to use either of these tools, you simply stay away from them, and that is how credit SHOULD be viewed. It is a tool in the financial process which should not be used by those who have no ability to control their spending, or those who are well versed in the art of money management. Unfortunately, the same way that there are people who are given drivers licenses and then abuse the privilege the same happens with credit.

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Kevin@OutOfYourRut 2010/03/11 at 7:36 pm

Eric – I see your point on leverage in the right hands. But please understand, that’s not the angle I see debt from.

Matt and Paul said it well above, it’s about freedom; that’s the angle I approach it from as well. Especially now in an uncertain economy, it’s best to travel light, with the fewest encumberances possible. We can’t afford to have our options constrained by being weighed down with debt.
.-= Kevin@OutOfYourRut´s last blog ..Why It Might Be Better to OWE on Your State Income Tax Return =-.

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Eric J. Nisall 2010/03/12 at 5:53 am

Kevin, I totally understand your viewpoint, and to some degree I do agree. But at the same time, you mention freedom and that is the way that I see credit to be an invaluable tool. For instance, before this whole debacle with the economy people had the ability to get what I call “real” mortgages (you know, 20% down payment or more at low rates with payments that weren’t eating up all of their net incomes). With the cash that wasn’t put into the home they were able to invest in themselves; putting larger sums into CDs or other high-yielding accounts, investing in income-producing stocks/funds/bonds, etc. and even paying off existing debt. This enabled the people who were responsible and managed their finances correctly plenty of freedom and flexibility.

My personal viewpoint is if I have the money to pay for something, but I can gain more from taking on some debt while using the cash in another way (like a 0% interest offer on a credit card for a major purchase combined with a high-yielding liquid account) then it makes sense to position myself to get as much utility from my money as possible. Understand, I’m not talking about frivolous items, and I’m not saying that this is how everyone should look at it because I can only speak for myself. Unfortunately, for one reason or another (not pointing any fingers here since there are a myriad of reasons and people responsible for this current state) things got out of control and credit became less of a tool and more of a crutch for people.

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Kevin@OutOfYourRut 2010/03/12 at 6:51 am

Eric – I can’t endorse the use of credit to leverage income. I’m not saying it’s categorically wrong, but that is IS wrong for most people. The problem is that investment values tend to bounce around, while debt levels are constant. That’s an unequal relationship.

You’re entirely right about “real” mortgages–until about 20 years ago mortgage lending was self policing; if a person got in too deep, they couldn’t borrow anymore. But the system decided that if a little debt is a good thing (to juice a weak economy), then more is even better.

That pretty much explains where we’re at right now in the economy. Two decades of easy credit caused people to lower their inhibitions about debt, so if we have a mortgage and a student loan, it’s OK to borrow more for a car or a dream vacation to the tropics. Debt has come to be viewed as a beneficent friend–which is the whole reason there really isn’t any such thing as good debt.
.-= Kevin@OutOfYourRut´s last blog ..Since when are you the quitting type? =-.

Jason @ Redeeming Riches 2010/03/12 at 4:51 am

Kevin – congrats on on the staff writer position – and Paul, nice job picking up a talented and insightful writer! Looks like a win-win!

I used to wholeheartedly believe in good-debt/bad-debt, but I’ve been transformed more and more through this recession and seeing the impact that debt in general has had on folks – it’s been difficult to come out of this and say, “yes, now that is some good debt!”

Good debt was termed because you had debt on an appreciating asset – or so we thought. That is until the housing bubble burst and folks were losing 10-20% or more of their values! But I thought houses always went up in value!?
.-= Jason @ Redeeming Riches´s last blog ..How Should We Help the Poor? =-.

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JoeTaxpayer 2010/03/12 at 10:31 am

Nice thoughts here. I find our attraction to the words good/bad to be curious.
I’d propose the choice between ‘debt’ a nonjudgmental statement of money owed, and ‘moron debt’, the $10K owed on one’s credit cards due to too many dinners out and trips one couldn’t afford. Are you a moron for borrowing to go to school? Probably not. Buying a house? Well, maybe. As you say, there are responsible mortgages, your guidelines providing the framework I dare say would have avoided much of the crisis these past two years.
I’d not get crazy about early payoff, that’s a personal decision. A 30 yr old can get a right-sized mortgage, and find he’s budgeting to load up his 401(k) and not wanting to commit to tying up his money by paying early. At 40, he sees that rates have risen so he’s able to get a higher return in treasuries than he pays on the mortgage. No objection to that. Different guy says that being debt free is his goal number one. He borrows on a 15 yr mortgage, pays it in 8, and says the bit he might have come ahead would not have been worth the debt hanging over his head the extra 22 years.

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Kevin@OutOfYourRut 2010/03/12 at 10:51 am

Joe – Totally agree with what you’re saying, but I think that it has to start with a basic aversion to debt in general. So the reasonable person takes debt, but does so specifically, reluctantly with respect for the consequences, and with a practical plan for paying it back.

Good debt is a term that’s been floating out there, whether or not we choose to recongnize it, and the problem is that good debt often equals perpetual debt. We start scheming to stay in debt because it’s tax deductible or we don’t want too much dead equity in the house.
.-= Kevin@OutOfYourRut´s last blog ..Since when are you the quitting type? =-.

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Jackie 2010/03/12 at 2:28 pm

I’m not a fan of debt of any sort, so it’s all bad to me. I can’t wait to be rid of our mortgage. I think that the biggest reason debt is bad is because it hooks you in and then it’s hard to get out.
.-= Jackie´s last blog ..Now is Exactly the Right Time =-.

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Kevin@OutOfYourRut 2010/03/12 at 3:30 pm

Jackie, thanks for the comments on both sites! I completely agree, debt is a hook, and one that we put ourselves on too willingly sometimes. If you can stay out of debt apart from your mortgage, that should leave you that much more to pay the mortgage off. Good luck!
.-= Kevin@OutOfYourRut´s last blog ..Since when are you the quitting type? =-.

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Big Spender 2010/03/13 at 6:30 am

Good debt is easy to calculate… If the financial benefit is greater than the interest cost, it’s good. Companies borrow at 3% to make an 8% return.

If it costs you $20,000 in interest to go to college but you’ll make $10,000 a year more every year over the life of your career, then that’s good debt.

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RainyDaySaver 2010/03/13 at 11:29 am

To me, good debt is something that will result in an (evenutal) financial gain — mortgages and education fall under these categories. You’ll always have your education, which tends to increase your income, and if you hold onto your home after buying it, it will eventually appreciate in price (in theory!). Bad debt is credit cards and car loans, particularly because a vehicle depreciates the minute you drive it off the lot!
.-= RainyDaySaver´s last blog ..Don’t Beat Yourself Up Over Spending =-.

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The Rat 2010/03/13 at 12:38 pm

In my view, debt is debt, and there’s no way to ‘tippy toe’ around it. However, I think mortgages and education are considered to be more ‘worthy’ investments as they are considered long-term investments in comparison to say, a vehicle so I think there is reason to differentiate them.
.-= The Rat´s last blog ..Setting Up An Online Discount Brokerage Account & Investing On Your Own =-.

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Kevin@OutOfYourRut 2010/03/13 at 2:45 pm

Big Spender, you’re completely right about big companies and their ability to leverage money by borrowing low, and investing high. But the achilles heal from an individual perspective is that it takes enormous amounts of money to do that profitably and consistently. Also, for many large companies, that’s their business, so they’re also prepared to take the hit if things go against them. Ordinary people don’t have the ability to borrow at 3% and lend at 8%.

Rainy Day Saver – Good analogy, but you have to factor in that debt is a given, a fixed cost that will need to be paid back even if the promised benefits don’t occur. By contrast, the promised benefits are projections, not guarantees. Should we be accepting guaranteed debt in exchange for projected financial benefits?

The Rat – Well put!
.-= Kevin@OutOfYourRut´s last blog ..Since when are you the quitting type? =-.

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paul 2010/03/14 at 1:15 pm

What a fantastic discussion going on around here, look at you Kevin getting the people fired up. I love it and thanks all for giving your points of view this is what FiscalGeek is all about!

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Financial Uproar 2010/03/19 at 3:05 pm

I’m a little late to the discussion, but here’s my thoughts.

Mortgages and student loans can be both good and bad debt. If you go to university for a useless degree, that student loan is hardly good debt. It’s the same thing when you take out a mortgage that you’d be better off never touching. In that situation, the borrower would be better off without the debt.

Yet if someone turns their political science degree into law school, is that not good debt? 50k in law school debt could easily double this person’s income. Say at 5% interest, it costs someone $2500 per year to make $50k more. You’d be crazy not to do it.

Same thing with mortgages. Say I buy a house that over 30 years will double in value and that I pay the same amount in a mortgage that I would pay for rent. In 30 years, I’ll own a house that will be worth double what I paid for it, plus I get the privilege of living without a payment after it’s paid for. Generally (present situation excluded for you Americans) housing is a good investment. Either way, I waste money. (on rent or interest) That is also good debt.

Big Spender’s comment nails it as well.
.-= Financial Uproar´s last blog ..You’re A Sucker To”¦ Cut Up Your Credit Cards =-.

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Kevin@OutOfYourRut 2010/03/20 at 2:41 pm

Financial Uproar – I agree with your reasoning. Incurring debt for a stacked deck bet, i.e., medical school, might be a true good debt. The problem is that with today’s benign view of mortgages and student loans, there’s a general sense that any degree is a good investment (which is no longer true) and for a time it was believed that a loan on any propery was a good investment.

Both can be good debts under the right (very limited) circumstances, but the reality is that too many people are getting over their heads even with good debt.
We moved into a time when excess debt became the “conventional wisdom” and that’s dangerous state to be in, individually or collectively, as we’re now seeing.
.-= Kevin@OutOfYourRut´s last blog ..OutOfYourRut Friday (but almost Saturday) Personal Finance Round Up =-.

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Financial Uproar 2010/03/21 at 11:08 am

The abuse of debt isn’t a good thing, whether it’s good debt or bad debt.

But to say that good debt isn’t good because people abuse it is an insult to the millions of people in North America who use debt intelligently. Debt itself isn’t the problem; the problem is people using it incorrectly.

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