Good Debt, Bad Debt

Nothing is more exciting than showing an investor when they will become a millionaire. Faces light up when they see the student loans disappear into the horizon or when dreams of a lake house take shape. This sounds great, but it can feel impossible when everyone from everywhere is always talking about debt and trying to get rid of it.

Real estate and college are more expensive than ever, and many people have those financed. But aren’t homes and education a good thing? Then there are car loans, credit cards, personal loans, business loans, and all types of debt. How come it seems everyone has debt, but some people have it worse than others? It also seems like the most successful people can sometimes have the most debt.

Debt can be good or bad. A business regularly generates a balance sheet, a report showing assets on one side that are balanced by liabilities (debts) on the other side. When I work with investors, one of the first things we calculate is a personal balance sheet, also known as a net worth statement. We start by adding up all your assets, which includes savings accounts, investments, real estate, business ownership, retirement accounts, and so on. Then, we subtract the money that is owed like student loans, mortgages, credit cards, and any other debts or loans. The difference is your net worth. My goal with clients is to increase their net worth. To do this we focus on increasing assets while shrinking liabilities.

As long as the debt to asset ratio is healthy, I’m generally not too concerned with the debt. Mortgages and car loans generally have pretty favorable interest rates, and they are tied to assets which can be sold eliminating the debt. As long as the asset, such as your home, is greater than the corresponding debt, like the mortgage, than there is a positive relationship between the debt and the asset. If you sell your home, your mortgage is paid off upon the sale, and you get to keep what’s left (also known as equity).

With a healthy debt ratio and low interest rates, an investor will generally be better off investing their surplus income in the market than paying off a loan. This is often referred to as opportunity cost, the cost foregone in one option by pursuing another. In the end it comes down to numbers and running some math to see what improves the balance sheet more, increasing investments or reducing debt. Once determined, pursue that option.

What I look to eliminate is unhealthy debt like credit cards and high interest personal loans. These types of debt are considered “unsecured.” In other words, there is no asset which can be sold to repay the debt. Because there is no directly offsetting asset, interest rates can become quite significant. It is extremely difficult to find reasonably safe investments that can outpace credit card rates. I should note, paying your credit card off every month means you are not carrying the debt and therefore not paying this high interest.

I’ve dodged the elephant in the room up until now, and that is student loans. These are very common and can be extremely overwhelming. Student loans, however, are not necessarily bad. You might not have your career without them. While I can devote an entire blog post to them (and probably will), my general feeling is that the interest rates are not typically outrageous. If your loan rates do seem high, explore refinancing them. It is important to pay off student loans and to be mindful that they only occupy one side of your net worth statement. I encourage investors to focus on accumulating assets while simultaneously paying off student loans.

Determining what debt is good and bad is relatively simple. Going about paying it off presents some complexities with many variables to consider. I mentioned mortgage debt is typically good, but if you are near retirement, it may make sense to pay it off before retiring. Working with a CERTIFIED FINANCIAL PLANNERTM professional can help model out different scenarios and answer these questions. Sometimes managing debt comes down to math, sometimes it is balancing emotions, and sometimes it is correcting a behavior. The answer isn’t always simple, but there is usually an answer.

Remember, the goal is to keep your net worth increasing during your working years by paying attention to both sides of the balance sheet.

Happy Investing.