For many people, debt is a necessary evil, or even something to avoid at all costs. But debt is actually not a black and white issue. Not all debt is bad, but not all debt is good either. In order to avoid financial ruin and maximize your money’s potential, it’s important to know the difference between good and bad debt, how much debt you should have and how to make debt work to your advantage.
Paying interest on an item that depreciates in value over time is the definition of bad debt. Most credit card debt, especially when used to purchase clothing, electronics or other everyday items, is bad debt. Using this definition, a car loan is also an example of bad debt. Your car loses value as soon as you drive it off the lot, yet you’ll be paying interest on the loan you took out for years. Going into debt for vacations, food or other consumables is a bad use of your money because you’ll be paying interest long after the purchase has been consumed.
Student loans, business loans and mortgages are generally considered to be good debt. That’s not to say you are in bad shape if you don’t have these debts, but rather, it’s not a bad financial move to take out a loan for educational expenses or a home if you can’t afford to pay cash. What makes these purchases different? They all have the ability to increase your wealth over time. You’re taking on debt to invest in something and potentially make more money in the long run.
A student loan is an investment in yourself; the idea is that you’ll have better job prospects with a college degree, which will allow you to not only repay your loans and interest, but also continue earning more throughout your life. Similarly, a business loan allows you to create a new way of earning money— assuming your business is successful, you’ll be able to pay off your loans and still continue to build wealth. It takes money to earn money, so a loan may be the only way you can afford to start a business. A home mortgage gives you a
Student loans, business loans and mortgages are generally considered to be good debt. What makes these purchases different? They all have the ability to increase your wealth over time. place to live and the opportunity to build equity when you most likely couldn’t afford it on your own. Real estate generally increases in value over time, so mortgages are also seen as good investments for the future.
Leveraging your debt—borrowing at a low interest rate and investing at a higher rate of return—is also good debt. The most common occurrence is investing in a home through the use of a mortgage. But there are other ways to make your money work harder using debt.
When you take on a loan, you owe a certain percentage of interest on that loan. Similarly, when you invest in the stock market, you get a percentage of interest added to your investment, depending on how well the market does. If the percentage of interest you earn is greater than the percentage you pay, you’re successfully leveraging your debt. When done correctly, leveraging can be extremely effective at building wealth. This type of investing can have much higher returns than regular investing, but it also carries higher risk—if your investment doesn’t pan out, you not only lost the amount you invested, but you also owe interest on your loan. Leveraging also doesn’t work if your interest rate is too high or your rate of return is too low. Investing when you have credit card debt is a bad idea, because no investment can guarantee a return higher than your credit card interest rate. It’s also a bad idea to borrow money just to have it sit in a low-interest savings account—the interest you’re paying must be lower than what you’re earning on the investment, or you’re not successfully leveraging your debt.
If you’ve used a credit card before, you probably realize that credit is not “free money.” You do eventually have to pay it back, and you’ll pay interest on top of that if you don’t pay it on time. Paying only the minimum balance each month may leave you paying more than double in the long run. Since credit card debt is bad debt, you might be tempted to avoid credit cards altogether. However, there are some benefits to using a credit card:
Rewards points: Many credit cards offer rewards programs that provide cash back and other incentives based on how much you spend. It’s not a smart idea to spend more in order to get rewards, but if you’ll be spending money anyway, it can be beneficial to put those charges on your card—only if you pay off the balance in full every month.
Build credit: Having a history of responsible credit use on your credit report will help you when applying for loans in the future. If you can regularly use your credit card and pay it off you’ll build credit while avoiding fees and interest.
Security: A credit card is generally considered to be more secure than a debit card or cash—you can dispute fraudulent charges more easily or cancel the card if it’s stolen. If you’ll be using a card anyway, such as shopping online or at the gas pump, it’s safer to use credit than debit.
If you have too much debt, lenders may be less willing to extend further credit to you, and you risk not being able to pay it all back. If you don’t have enough debt, your money might not be working as hard as it could be. There’s no scientific way to quantify exactly how much debt each individual should have. Many experts agree that your monthly debt payments should not exceed 36 percent of your monthly gross income. This ratio will change depending on your living expenses, lifestyle and personal feelings about debt. There are three factors to consider when deciding how much debt you can comfortably take on:
You can use several ratios when determining how much debt is appropriate. You can compare your monthly debt payments to your monthly income, your combined debts to your assets, your housing expenses to your monthly income or your monthly consumer credit payment to your monthly income, among other ratios. Advisors will recommend various ratios as ideal—your housing expenses shouldn’t exceed 28 percent of your income, and your monthly credit card payments shouldn’t exceed 20 percent— but it’s important to take your own unique situation into account.
It’s important to understand that debt is not all good or all bad. If you acquire the right kind of debt, in the right amount, and use your credit cards wisely, you can become more financially successful than you would have without the use of debt.
This article was written by Advicent Solutions, an entity unrelated to Prudential. ©2020 Advicent Solutions. All rights reserved.
White Rose Wealth Management
Peter Kelly
White Rose Wealth Management is not an affiliate of Prudential Financial. Pete Kelly sells insurance products of Prudential Financial's affiliated insurance companies in addition to products of non-affiliated insurance companies. White Rose Wealth Management and its representatives do not render tax or legal advice. Please consult with your own advisors regarding your particular situation.
Peter Kelly offers financial planning, Aaron Trinh offers investment advisory services through Pruco Securities, LLC(Pruco), under the marketing name Prudential Financial Planning Services (PFPS), pursuant to separate client agreement. offering insurance and securities products and services as a registered representative of Pruco and an agent of issuing insurance companies. 1-800-778-2255.
White Rose Wealth Management, LLC is not affiliated with The Prudential Insurance Company of America and its affiliates, including Pruco. Other products and services may be offered through a non-Pruco entity. Peter Kelly, Aaron Trinh, nor White Rose Wealth Management, LLC do not render tax or legal advice. You should consult with your own advisors regarding your particular situation.
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