Debt: The Good, The Bad, and the Downright Ugly

"Neither a borrower, nor a lender be," cautions Shakespeare in Hamlet. The reality is, most of us carry debt. From a money management standpoint, that is not necessarily bad. Sometimes debt is good. Sometimes it’s downright ugly. The key is to carry the right kind of debt, and not too much of it.

Most Certified Financial Planner practitioners recommend that no more than 10 to 15 percent of a person’s take-home pay go to non mortgage debt. That’s debt that’s paid to student loans, car loans, personal loans, credit cards and so on. Just as important is carrying the right kind of debt.

Good debt. Good debt generally is debt that can provide a long-term financial payoff. Educational loans—either for your children or perhaps career education for yourself—is a good example. The improved earning power from the education should more than pay back the cost of the loan.

Mortgage debt is another "good" debt. To begin with, few consumers can afford to pay cash for a home. Also, a mortgage is good debt in the sense that a home is an investment: most homes appreciate in value over time.

The bigger issue is whether homeowners should pay off their mortgage early if they can. Say you have a 30-year mortgage and you come into an inheritance that will allow you to pay it off. Or you’re thinking of paying extra toward the principal each month, which can dramatically cut down the total interest you pay. Should you?

That depends. Let’s assume you can reasonably expect to earn a higher return investing the extra money than the interest rate you’re paying on your mortgage. Keep in mind that the tax break you get for a mortgage decreases its real cost to you. If you have an 8 percent mortgage and you’re in the 28 percent income-tax bracket, you’re really only paying 5.76 percent on the loan. You probably can reasonably invest your money over time for a higher return than that, though taxes might eat away some of the difference unless you put the money into a tax-deductible retirement plan or IRA. On the other hand, if you’re paying a very high mortgage rate, that may be the better place for your money (consider refinancing, too).

Car loans could fit into the "good" or "bad" debt category. Borrowing to buy a car that you need to get to work is usually justified. However, unlike most homes, most cars lose value over time, often quickly.

There is such a thing as too much "good" debt. Busting your budget by buying the most expensive home you can possibly afford or a high-end sports car to get to work generally isn’t financially wise.

Bad debt. This tends to be short-term debt in which the loan lasts longer than the item you bought with the debt, and for which there is no financial payback. Most credit card debt falls into this category. People pay for everything from dinner to toys to clothing to vacations on their credit card and they’re still paying for them long after the vacation is done or the toy is broken. Also, credit card debt tends to be very expensive—18 percent or more is common.

Loans for furniture, appliances, cars and other personal needs also can be fairly expensive, though usually not as high as credit cards. Save for these items whenever possible and pay for them in cash.

Ugly debt. Some people would lump credit cards in this category, and it is a tossup. But we’ve reserved this category for the really expensive debt that comes from what’s commonly called "fringe banking." This includes "payday loans," unsolicited loans in the mail ("take this check and cash it"), interest on pawned items and furniture rental (where you end up paying a lot more than if you’d simply borrowed from your credit card to buy the TV set). Interest rates for some of these loans can run 25 percent to 100 percent or more.

Living with minimal debt will help create more abundance in your life and is key in the development of the fundamentals of financial success. As a rough rule of thumb, many planners recommend that people aggressively pay down any debt whose interest rate runs 10 percent or more. For rates lower than that, you’ll have to evaluate whether to pay off the debt or use the money for investments or perhaps an emergency fund.

TIP: Watch out for carrying balances on credit cards. Some cards charge 20% or more in interest. (Interest is usually called "Finance Charges" on your statements.)

Reprinted from Zongoo! Finances