Dollar Scholar Asks: When Can Debt Be a Good Thing?
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Jumbo shrimp. Same difference. Good morning.
These are some of my favorite oxymorons, or phrases that combine contradictory words for rhetorical effect. (Another funny one is the Dolly Parton quote “You'd be surprised how much it costs to look this cheap.”) An oxymoron is a figure of speech often intended to add humor to a literary work…
…or to confuse personal finance reporters like yours truly.
Seriously: For years, I’ve been tripped up by the term “good debt.” I write all the time about how crucial it is for people to stay on top of their obligations and minimize any balances they carry from month to month. I urge readers to avoid debt, not accrue it. And now you’re telling me debt can be good?!
I’m tired of this oxymoron making me feel like a moron.
What is 'good' debt, and how does it differ from 'bad' debt?
Adrianna Adams, a certified financial planner with Domain Money, tells me that good debt includes liabilities that 1) increase my net worth, 2) significantly enhance my life and/or 3) provide future value.
Take a mortgage, for example: It’s a hugely expensive debt that will take me decades to pay off, but in the end I’ll be left with an appreciating asset that has major value. (Some financial experts say homeownership is the key to building generational wealth, though Dollar Scholar has previously debunked it as the only way to unlock the American dream.)
Student loans tend to qualify as good debt, too. Like with a house, I’m taking on that debt as I work towards the larger goal of getting a degree that will, in turn, increase my ability to earn a higher income. Research shows that young workers with college degrees out-earn their high school graduates by $22,000 per year.
To be clear: Having debt is extremely normal. According to a recent report from the Federal Reserve of New York, Americans collectively have $17.5 trillion — with a T — in household debt.
And having some debt is actually necessary in order to build my credit, says Keith Jones, senior financial advisor with Empower.
That’s because credit scores are based on factors like my payment history, length of credit history, credit mix and credit utilization ratio. Having multiple types of debt can contribute to my credit mix, making it more diverse, which sends a signal to lenders that I’m able to handle paying off multiple types of debt at the same time.
Admittedly, it’s an odd time to be a borrower. The Fed has hiked rates 11 times in an attempt to curb inflation, making it extremely expensive to borrow money. A July survey from Northwestern Mutual found that the average American's personal debt is $21,800 not counting mortgages; more than a third of respondents said they’re already at or carrying close to their highest level of debt ever. And that was before student loan payments started again in the fall.
This is where “bad” debt becomes a major factor. Stressed about making ends meet, borrowers are likely to seek solutions that lead them to take on bad debt, which is easily identified by its high interest rate.
Jones says if I have debt with an interest rate higher than the expected rate of return of my investment portfolio, usually about 10%, it’s considered bad. Common examples include credit card debt and payday loans.
And here’s the kicker: Having bad debt can actually lead me to carry more bad debt.
For instance, say I’m carrying a bunch of credit card debt from month to month and not making on-time payments. This will decrease my credit score, putting low mortgage rates out of reach and ultimately making my debt snowball.
As such, Jones advises me to be aggressive with paying down bad debt. Adams suggests reaching out to a financial planner to learn more about options like debt consolidation, refinancing and negotiating with my credit card company.
I don’t want to let too much good debt accumulate, either.
“Even if a debt can be considered ‘good,’ it is still a debt and something that you owe,” Jones says. “If you have too much debt in general, it can impact your ability to save and allocate your money to reach your financial goals.”
The bottom line
Good debt is low-interest debt that appreciates in value and/or helps me increase my net worth (think: student loans or a mortgage). Having some good debt can improve my credit score, but I do need to be careful not to go overboard lest it turn into bad debt.
More from Money:
Do I Need to Worry About the National Debt?