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Using Debt Intelligently: Good Debt Versus Bad Debt

Digging a hole

Time to dig out of debt.

There should be no battle between good and bad debt. Debt is not good or bad in and of itself. Debt is a tool that can be used to simplify personal and business finances or can be used with reckless abandon. The internet is filled with advice on debt. In one corner is Dave Ramsey and his ilk claiming all debt is bad and should be avoided at all cost. In the other corner is Donald Trump and his “There is never too much debt” mantra. Only rarely is someone smart enough to discern between the two camps and provide appropriate advice on debt. Today your friendly Wealthy Accountant will be said smarty-pants.

Dave Ramsey hates debt because he doesn’t know how to use it or how it works. He used debt incorrectly and ended up in bankruptcy court so he preaches “all debt is bad.” Donald Trump has no problem going to bankruptcy court. He claims he can always strike a deal later on to reduce his debt. (I use Donald Trump as an example most are familiar with. This blog is not about politics and will refrain from endorsing or condemning any political candidate in the body of the blog or the comments.) As much as Ramsey avoids debt, Trump is attracted to it. Neither position is healthy.

I tend to side more with Ramsey than Trump when it comes to debt. Most debt is “bad” debt as far as I am concerned. Nobody ever lost their home in foreclosure without a mortgage. Less debt is usually better, and if I was forced to one side or the other, Dave and I would end up chums. As a disclosure, my accounting firm was a Dave Ramsey Endorsed Local Provider (ELP) for many years.

We will begin with an illustration. If I told you I have $1 million in debt what would you say? Is it too much debt? Am I putting my net worth at risk? Let me add that I have $100 million in real estate with $28 million in revenue per year. Now is $1 million too much debt? Actually, $1 million in debt is nothing to the very rich. It would be the equivalent of owing your buddy $2500 when you earn $80,000 at your job and have a quarter million in the bank.

The above illustration highlights one important lesson to learn about debt: a small amount compared to income and net worth is insignificant in a financial plan. Even the most well run companies and households use small amounts of debt to manage their business needs more efficiently. Credit cards are really debts you pay in full each month. Since credit cards are convenient and pay cash back or travel rewards, the debt makes sense to me as long as you actually pay the card in full each month, avoiding all interest charges. The line between ‘good’ and ‘bad’ debt is a thin one indeed; one I will clearly highlight for you.
Bad Debt

Bad debt gets the majority of press time so we will start there. Bad debt is easy to see after the fact. Financial troubles highlight where debt usage went wrong. Some debt is okay at one moment and terrible a second later. Here is a list of the worst debts to have:

  • Payday loans: There is never a time where these loans are a good idea.
  • Car loans: If you don’t have the cash, you can’t afford the car.
  • Margin loans: You do not borrow money to buy stocks, bonds, or mutual funds.
  • Credit Cards: Credit cards belong in the ‘good’ and ‘bad’ camp. Credit card interest is bad and the interest rates are too high, but using a credit card for cash back or travel rewards is sound financial management as long as you do not carry a balance.
  • Most personal loans: Lending Club and Prosper are great investment vehicles, but a terrible place to borrow money.
  • Consumer loans: Debt held on wasting assets or from personal consumption makes no financial sense ever.

Debt from the above list is a crisis! If you have any of the above debt you need an immediate action plan to destroy it. With the exception of short-term credit card debt paid in full each month, you should have no debt from the above list, ever. I get the most push-back when I tell people car loans are out. My reasoning is still sound; buying a wasting asset on credit is financial suicide. If you do not have enough to pay cash for the car you want, buy less car! Let me change that. Even if you have cash burning a hole in your pocket, buy less car. Cars are not an investment; they are wealth destroyers. Doubling down on stupid only makes a bad deal worse.

Fixing Bad Debt

Bad debt is a CRISIS! Everything in your financial life comes to an immediate halt if you have any debt from the above list. If you are able to bring in more money, do it. Apply all the extra income to paying down the bad debt. Think of it this way. The interest rate on the above list of debt is massive at 10% or higher in most cases, with the exception of some car loans. Where else can you get a guaranteed 10% rate of return on your investment tax-free than paying off high interest debt?

More important than additional income is cutting expenses. It was spending that got you into this mess; cutting spending is the only long-term solution to ending permanently the debt cycle. When you have a debt crisis it requires emergency actions to the family budget. Here is what has to be done (I don’t care if you don’t like it):

  • Cable is out; so is Netflix and any other time/money wasters. Cable/Netflix are luxuries for the wealthy. Plow the cost of cable into debt payments.
  • Dining out is out. Brown bag it. I rarely go out to eat, including when at the office, and I have money.
  • Walk or bike to work.
  • If available, sell the car and use public transportation or bike to work.
  • Pay off the highest interest rate debt first. I know this goes against Dave Ramsey teachings, but I am more interested in building net worth as fast as possible.
  • Make a list of all your spending and start cutting. Only the essentials stay: food, clothing, medical, and shelter.
  • Smoking, drinking, parties, are out. Invite friends over for a BBQ in the back yard for entertainment. BYOB.

Every rule has exceptions. When it comes to debt, no matter how bad it is, medical issues can be a massive problem. If a family member has serious medical issues, they are the priority. Too many families are destroyed by medical and medical caused debt. My heart goes out to you if you are in this situation. Your family comes first. Minor medical issues are another story. Medical issues are never to be used as an excuse for bad financial decisions. Debt, even bad debt, acquired due to medical is an unfortunate consequence of the health care system in the United States. Serious medical issues also mean you cut all other spending to the bone. A medical crisis causing debt issues does not give you permission to buy that sporty new SUV.

Good Debt

There are only a few areas of ‘good’ debt in my opinion. I allow debt for the purchase of a primary residence, income properties, and for business needs. We need to be careful when we say ‘good’ debt here. It is too easy to have too much of a good thing. Debt for real estate or a business has the strong possibility of either producing a positive revenue stream or the underlying asset will increase in value, hence the term: ‘good’.

A mortgage on your primary residence should have no less than 20% equity and preferably 50% or more. Forget the tax deduction; pay off the mortgage as quickly as possible. With low interest rates today it is easier to eliminate all personal and mortgage debt. Income properties are the same: no less than 20% equity and pay off the debt like your life depends on it (it might).

Business debt is different. My accounting practice was built from scratch; no debt required. The office building is unencumbered and the business has no loans outstanding. When I purchased the office I had a land contract for five years. The seller refused to sell for cash because of the tax hit so I paid the building off over five years. The office has never seen a penny of debt since.

Businesses also need working capital. My practice has a line of credit, rarely used. Sometimes it is good business planning to use short-term debt. The office line of credit never goes more than a few months when used; it is only a stopgap measure. Business owners need to be cautious when using debt. It can quickly turn into bad debt. Remember, really small amounts of debt are instruments to manage personal and business finances, not a long-term business strategy or solution. Debt creates interest which is an expense.

Using Debt Wisely

I want to share one idea to reduce debt, even ‘good’ debt, quickly. The idea is to reduce and eliminate all debt as fast as possible. Just because we call some debt ‘good’ does not mean we like having lots of it. My idea works best for people with a good credit rating.

Since the only debt we consider good is used to secure property or business, a line of credit is usually available. The idea works for businesses, but I will illustrate here as it applies to individuals. Assumptions: You own your home with a $250,000 mortgage. The home is valued at $400,000. The interest rate on the mortgage is 4% and you can get an equity LOC against the home at 4% or less. Many times lines of credit have lower interest rates than the original mortgage due to the short-term nature of the loan product. I would not use this idea if the LOC interest rate is higher than the original mortgage interest rate.

The strategy works like this: You get a $100,000 LOC on your home. Once the LOC is set up, borrow $20,000 from the LOC and use it to pay extra principle off the regular mortgage. From now on you will deposit all excess cash (paychecks, checking account balances, savings, et cetera) into the LOC instead of your checking account. Take money out when bills come due. Your short-term money used for daily expenses now reduces your mortgage balance, thereby reducing your interest expense. When the LOC is paid off, repeat until your mortgage is satisfied.

If you have bad debt you need to get aggressive and creative to annihilate it as soon as possible. Debt is the acid that destroys the vessel which holds it. Some debt on your home, income properties or in business is rarely a problem as long as the equity is bigger than the liability.

You know what, now that I think about, I agree with Dave Ramsey. Nothing feels better than to live debt-free.


Monday 11th of July 2016

I am a little confused by " Take money out when bills come due. Your short-term money used for daily expenses now reduces your mortgage balance, thereby reducing your interest expense." Are we saying use the LOC like a checking account or just putting the money on the LOC instead of savings?

Keith Schroeder

Monday 11th of July 2016

Yeah, Dave, I was clear as mud on that. I will do better. Once you have money moved from the LOC to the regular mortgage, the regular mortgage is now paid down by the same amount owed on the LOC. Instead of keeping float in your checking account/saving account, you can deposit emergency money, short-term money, and float (bills owed, but not yet due). Keep the bare minimum in your checking account. When bills come due, move money from the LOC to the checking account to handle the bills. While money is waiting to be used, including emergency money, you are saving/earning around 3% (your LOC interest rate). Does that make sense? Instead of making zero, or nearly so, on your emergency funds and checking account balance, you now earn the LOC interest rate because you don't have a loan on that money for the period of time it is sitting there. Again, for some people this makes sense, other, not so much. If you have good credit and are in debt pay down mode, this can give you an added boost. Also consider the cost of having a LOC (annual fee).

Jamal Mitchell

Saturday 9th of July 2016

Keith, I appreciate your blog. Very insightful! In your discussion of the use of "good debt" I'm a bit perplexed by the suggestion of using a HELOC to pay down a mortgage. Would making extra payments to the primary mortgage make more sense for those who are less risk tolerant? With HELOCs being variable interest rate loans, using one in a rising (although very slowly rising) interest rate environment may negate any benefits especially if the spread between the two loans is not large enough. I'm keen to hear your thoughts on this.

Keith Schroeder

Saturday 9th of July 2016

Jamal, I opted not to get too deep into the interest rate issue using a HELOC to keep the post manageable in size. I briefly mention the interest rate should be the same or lower. The concept is to allow "float" money to act as a reduction to your mortgage. There are many good ideas around the internet to reduce debt; my goal was to bring something somewhat new. If interest rates start rising slowly I would probably still like the idea but use a much smaller number: $5,000 versus $20,000. To maximize the benefits regardless of interest rates, only use what is needed so the LOC has almost no balance, or maybe debt-free most of the time. Most important, consider debt as a tool. When used correctly, the HELOC, or LOC in business settings, can be a powerful cash management tool.


Thursday 7th of July 2016

I agree that debt is a very sharp tool but, just like a knife, can work for you or against you. I used debt to buy my current car and, given my particular circumstances, feel it was a wise choice. Some years ago I had put some money aside in a CD for my next replacement car. Fast forward a few years and my car was on its last legs with engine issues. The CD was still chugging along with three months to go for maturity. I found a very good deal on a hybrid with some minor cosmetic damage. I tend to stay fully invested with only a few thousand in quick cash. The cost of the hybrid was a few thousand over what cash I had available. The cost to break my "car CD" early exceeded the cost of financing the balance I didn't pay in cash. So, I borrowed about $6k and paid interest for three months, about $40, until the CD matured. Not only did I net $5 or so on the difference between the financing cost and CD penalty, I know I saved far more on the purchase of the car than the what I paid in interest.

Keith, I'm curious about your position on educational debt. My daughter is about to start college full time next fall. She is currently a dual-enrollment high school/community college student and doing quite well. While we could pay her (in-state) tuition out of pocket, we are leaning towards simply offering her a fixed dollar amount towards her education (like $40k total @ $10k year...paid at $5k per semester)...which should cover about 2/3 of her bills. She can either work and pay the remaining balance herself or take student loan and pay from her future earnings.

She currently has a small amount of savings from her own work. She started earning taxable income this year but we are really thinking about setting up a custodial Roth at Vanguard (VTTSX) for the bulk of her earnings. We are currently researching how that might affect her eligibility for financial aid but feel that in her long-run fully funding a Roth at her age should take priority over school expenses. Thoughts? Thanks!

Keith Schroeder

Thursday 7th of July 2016

Jon, student loans concern me; they are hard to discharge in bankruptcy (not that you plan for that). I love your idea of providing a set limit for education expenses. This lets your daughter know she needs to either get scholarships, grants, a job, or loans on her own. Like many readers here, you could write a check to cover the whole thing; I think it sends the wrong message. Your daughter needs to invest in her future. I also agree funding retirement accounts is a priority; the younger you start the more you will have.

You indicate you will cover around 2/3 of her education expenses. That is a good ratio. Scholarships and a job should cover most of the rest. Finally, I would tie the $5,000 you will pay per semester to grades. Your daughter sounds well grounded, but just in case, I would tie money to performance.

Sheeri K. Cabral

Wednesday 6th of July 2016

What about 0% interest car loans? Assuming you make all the payments, of course. Let's say you pay over 5 years....with inflation being what it is, doesn't it make more sense to take out a 0% interest loan? Because $500 in 5 years will be worth less than $500 today...

Steve Dye

Wednesday 6th of July 2016

Still it's hard to pay off a perfectly good mortgage early when other business / real estate investments return so much more. :)