The debate over good debt and bad debt may never be agreed upon. Pick any day and you can find an article written about the benefits of borrowing money to fund certain major purchases such as a mortgage for a house or a loan for a car or something more frivolous. I’m adding to the articles that do not think debt is good for most people.
People start getting into financial trouble with bad credit card debt which is a type of loans to deal with. Those who bought houses with interest-only and variable interest loans know another type of financial problem to deal with.
My wife and I were smart and maintained good credit scores as we have always paid all bills in full and on time each month and maintain a high level of available credit that we do not tap into. Both factor into improving our credit scores. We never focused on trying to determine what is a good debt ratio for us, it just worked out well for us since we never bought what we couldn’t afford. In turn, we get better interest rates when we borrow and stay further away from paying needless interest on debt. We save our money first instead of paying some company interest. After we have the interest boosted savings we buy whatever items others might use debt to get sooner. It’s a double win for us, interest earned and no interest paid out.
You can’t change what happened in the past, but you can make a plan to improve the future. I have an issue with a debt agency that doesn’t provide advice on how to change your spending habits and only issues a bad credit debt consolidation loan as a solution. That’s a patch at best.
The question ends up being when is debt good and when is debt bad. My opinion is that all credit card debt is bad. Don’t mistake that with credit cards are bad. We use a credit card for 85-90% of our purchases and get money or points for each charge we make. We pay off our credit cards in full each month. Again, a double win for us, no interest paid out and we are actually paid 1-3% on all purchase. Among other reasons, credit card debt is bad because with a missed or late payment the interest rate can jump from a low teaser rate to over 15-20% before you know what happened. That can be the beginning of a slippery slope.
A fair way to consider if other debt is bad is to consider what rate of return could you get for that money if you were not paying interest on it. Some car loans are OK when you get a special rate under 5%. On average you can make more than 5%, even after taxes in stocks. That means if you have the choice between investing in stocks or paying cash for a car, the more profitable choice is investing in stocks and borrowing the money for a car. The mental load of having a high fixed monthly payment can be too daunting to make this route worth the money for some. Once you have more money banked, the stress of the monthly payment goes away as you know you have cash available to pay off the loan at any given time. This is an example of how the rich can get richer so easily. In essence, they are using the bank’s money to pay for their car while they use their own money to make more money through investments.
The decision gets tougher as the interest rate increases. For a home loan the interest rates are currently higher for a fixed rate, but you get to write off the interest on your taxes. Some people are blinded by this write off and forget that they are still paying that interest and not keeping it. Writing off the interest only makes it pre-tax payments on your interest, not no payments. That means that someone who isn’t a successful stock investor should focus their attention to paying down their home and auto loans first and then focus on investing second. (I didn’t mention paying credit cards off first because anyone with credit card debt shouldn’t be taking on a home mortgage or large car loan. All resources should first be devoted to eliminating the credit card debt.)
We did a mixed approach with our finances since it does not have to be an all or nothing endeavor. While I was working on my investing model and learning how to consistently create better than average returns we paid off both of our cars and put down a sizeable down payment on our house. This left us with two reliable cars and a relatively small house payment for the house we own. Our fixed expenses are low and debt is manageable. If you are not reading this article on www.mytradersjournal.com you are reading it from a site that has plagiarized it.
Once I started hitting my stride by investing in stocks through options, we changed our focus to making bigger “payments” to our investing account. If I can maintain even half of my rate of return for this year on a regular basis we’ll be able to take on more debt instead of paying off everything in advance because the premiums I am receiving from investing will more than pay for it, even after tax. Since we used this model of living debt free we now only use 20% of my take home pay for living expenses and 80% goes towards investing. This explains how we’ve been able to have such explosive growth in our brokerage account this year on top of the gains I’ve been making.