In my Financial Essentials class, Week 2 often covers the topic of debt. It starts with a conversation about compounding interest, and how this “Eighth Wonder of the World” can either hurt you or help you through “good” or “bad” debt.
But a recent conversation with a friend has me thinking: Is there really any such thing as good debt for the typical family?
I’d like to discuss two forms of debt which we gladly justify--or label as “good debt”--and for a moment take a contrarian view as to why these commonly accepted forms of good debt may not be so great.
“Good Debt” Example #1: A Mortgage
Millions of US homeowners agree: mortgage debt is “good debt.” Mortgages tends to carry low rates of interest, provide tax deductions for interest expenses and property taxes, and properties build equity and increase in value over time (though arguably, not as much as you think).
But the costs of homeownership shouldn’t be ignored. As I’ve noted recently, being a homeowner is a costly endeavor. Here is a short list of the expenses you might pay, in addition to your interest on the debt:
- Realtor fees (when buying or selling)
- Lending fees (including for a refinance)
- Private mortgage insurance
- Homeowner’s insurance
- Flood insurance
- Property taxes
- Overall maintenance and upkeep of the home
If going into debt brings such added costs, can it be considered “good debt?” Many of these costs, in fact, don’t go away once your mortgage has been paid off.
“Good Debt” Example #2: Student Loans
When I enrolled in college, I was happy to take out student loans to pay the cost. The logic for doing so makes sense to most people: You can borrow money at a low interest rate for a future increase in earnings.
But student loan rates aren’t cheap. Most rates I see are around 6 to 7% now, which is fairly close to the annual growth rate of the stock market.
Furthermore, not all college debt is the same. An accounting major graduating with $40,000 in student loans may not have much trouble finding good-paying work, but other, less marketable degrees with the same loan may have trouble.
The accessibility of “easy money” can often create an unbridled willingness to borrow, borrow, borrow--often at amounts that students would otherwise be uncomfortable with. “Easy” student debt does not a “good debt” make.
When Debt Might Make Sense
So is "good debt" just a wolf in sheep's clothing? Whether or not debt can ever be called “good debt” tends to come down to at least one key question:
Does the cost of your debt give you an economic advantage that would be very difficult, if not impossible, to reach otherwise?
I’ll explain what I mean by this. In 2008 I started my MBA at the University of Utah. Fortunately I was paying in-state tuition, but the costs of an advanced degree, like many others, were quite high. If I remember right, I budgeted about $40,000 per year for the two year program (that sounds really cheap today!)
I felt confident that the marketability of my MBA would be high in the future. I was earning $44,000 per year at my previous job, and MBA students were often graduating with jobs paying $70,000 and above. I was also flexible with my location. If there weren’t opportunities in Salt Lake City, I was willing to move out of the state to find work.
When graduation came, I negotiated myself into a position paying $75,000 per year, a 70% pay increase (Not trying to toot my own horn here, just illustrating the investment payoff.)
Could I have saved up to pay for my MBA entirely with cash? You bet. If I could have saved $10,000 a year for 8 years the MBA would have been paid for. But the MBA earned me a higher income much more quickly and led to additional raises within a couple years of graduation, which I believe kept me further ahead, rather than waiting and saving.
I hope calling into question traditional forms of “good debt” has been helpful to you. Be cautious about any type of debt obligation, regardless of its ancillary benefits. Debt is debt, and we tend to forget about the added costs which accompany it. If debt is going to work for you, consider what kind of economic advantage it can potentially provide.