“Good Debt-Bad Debt”
Good debt would be any debt used to purchase something that would provide a current and future benefit and have a reasonable chance of appreciating in value. Perhaps the most obvious example would be the purchase of a home. Certainly buying a home meets the ‘present and future benefit’ test. However, the collapsing housing market may have people wondering if purchasing a home meets the ‘appreciation’ test. On a short-term basis the answer is situational…meaning that, depending on your particular situation, you may find that your home is worth less than what you paid. However, long-term home ownership remains a worthy financial strategy and, while it may take several years, we’ll see rising values in the future.
Borrowing money for investment can also meet the test of ‘good debt’. Consider purchasing a duplex for $100,000 cash where net income is $15,000…or a 15% return on your investment. If instead of paying all cash, you borrowed $65,000 at 6%, your return jumps to about 30%!
Borrowing money for education is another area that could qualify as good debt if the result is a better paying job.
Let’s get clear about what bad debt looks like. Bad debt is any debt used to purchase something that depreciates/declines in value. My favorite example would be borrowing money, typically on a credit card, to pay for a vacation (Memorial Weekend?). While ‘fun’ might be considered a current benefit, this will fail the ‘future’ and ‘appreciation’ tests. The same applies for borrowing for entertainment, furniture, clothes or gifts. Clearly, you’ll want to figure out how to save and pay cash for these types of purchases.
Have your bank (or credit union) set up an auto-transfer of 2%-5% of each paycheck into a future expenses account. Use this account to pay cash for ‘extra’ or ‘non-monthly’ expenses. You’ll be surprised at how quickly the money accumulates in your account with this system!
Stewart H. Welch, III, CFP, AEP, is the founder of THE WELCH GROUP, LLC, which specializes in providing fee-only investment management and financial advice to families throughout the United States. Mr. Welch has been recognized by Money, Worth, Mutual Funds Magazine and Medical Economics as one of the top financial advisors in the country. He is the co-author of The Complete Idiot's Guide to Getting Rich (Alpha Books) and J.K. Lasser's New Rules for Estate and Tax Planning (John Wiley & Sons, Inc.). Visit his Web Sitewww.welchgroup.com. Consult your financial advisor before acting on this advice.