Debt. Such a scary word. Let’s start with what I believe is an accurate definition. Debt is when you owe a dollar and do not have a dollar. Leveraging, on the other hand, is when you owe a dollar but chose to use that dollar to do something better with it than pay off the debt. For example, you may choose to try to earn a higher rate of return in an investment than the interest cost you owe on the debt.
For some, just the mention of the word “debt” creates anxiety and fear. In most people’s world, debt is bad. Well I have some good news for you. That isn’t always the case. When evaluating debt, think of it as a spectrum. On one end of the spectrum, you have bad debt where the loan interest rate you are charged is high and the interest is not tax deductible. On the other end, you can have good debt where the interest rate is low and perhaps even tax deductible. By using this spectrum as a guide to when and how you should structure and eventually pay off debt, you could save yourself hundreds, thousands or even hundreds of thousands of dollars over your lifetime.
The prime example of bad debt is any consumer loan that helps to finance your lifestyle. According to a 2015 NerdWallet study, the average U.S. household with debt carries $15,310 in credit card debt and $132,086 in total debt. If you don’t have the cash flow to pay off your credit card each month, then it’s bad debt. Do you really need that new designer item, smart phone, or the hot “grown up toy”? If you don’t have the money to pay for something you want, consider saving up or buying a cheaper brand instead of putting it on your credit card. Interest rates on credit cards are exceptionally high, negatively affect your credit score when balances are carried forward, and can impact your ability to apply for a loan or a new line of credit. Bottom line, when it comes to lifestyle cash is king.
Adopting a good debt “mindset” is equally as important as avoiding bad debt. Good debt could be student loans, mortgages and even home equity lines of credit when used judiciously. In certain circumstances, interest paid on loans used for investment purposes may be deductible* and be an example of good debt. When you combine the possible tax benefits with the current low interest rate environment of today, you have the potential to create a beneficial structure for your debt. Another factor to consider is if the debt will likely increase your net worth over time. While all investments have risk and are typically not guaranteed, sometimes using debt to create future wealth can be a sound strategy. Just be sure you talk to a financial professional or mortgage specialist before taking out these loans to ensure you are getting the right type for you.
Debt isn’t a universal “dirty word.” Always look to make your debt work for you instead of working for your debt. Never take on more debt than your expected monthly cash flow and budget can handle. Pay off your bad debt balances every month, set reminders or even set automatic payments for your loans, and be conscious of what you are spending. If you do not have the funds to pay off bad debt, work to restructure it into good debt, such as a primary mortgage or home equity loan. For any good debt, always look for opportunities to restructure it into even better debt!
Based on your particular situation, and every situation is different, understanding how to properly manage debt can help to create tens of thousands to hundreds of thousands to even millions of dollars of additional wealth in the future. With interest rates at historic lows, getting started today is one of the most sane, sound, and simple things you can do for your financial success.