About a month ago I discussed “Bad debt” in part #1 of this two part series. If you missed that post, please take a moment to read that first.
In Part #1 we defined what debt is and determined that several things could be detrimental to your finances.
The basic ideas of incurring debt to finance travel, spend on dining, to purchase cars, and to inflate your general lifestyle are not the best uses of credit and acquiring debt. Based on your age and goals, paying off debt may also be more important to you now as opposed to taking on more monthly payment obligations.
In this post we will consider some good reasons why one might use credit or take on some long term debt. We will get into some specific details and examples. Finally will look at 5 broad categories of debt and discuss some reasons why people may need to incur debt.
When is debt good for you?
Sometimes the only way to make some big ticket purchases is to borrow money. These decisions could involve buying a house, a car, or paying for a college education. I certainly have borrowed plenty for homes and cars over the years.
I feel that we could describe the “Good” use of debt into perhaps 5 broad categories. Here they are ranked in order of how they would most likely occur in your life:
1- Student loans
I would consider taking out a student loan only in the case of when your parents have not saved for your college, you are already working and living frugally, and the college degree you are seeking with have a fairly short ROI for repayment of the loan.
This means that once you are out of school you will have a fresh new job that will enable you to pay off these loans in maybe two to four years. During the school years you should live inexpensively at home or with roommates and also strive to pay for as much of your education cost as possible with your part time or full time job.
It would have similarly been prudent to save money on your own prior to college if you knew your parents could not assist with the cost. Of course earning excellent grades and scholarship money would be most helpful too. The bottom line intent is to minimize the amount you must borrow if that is your only option. Fortunately for me the first year was a scholar ship, the next 2 were my parents paying, and the last year was me footing the bill. No student loans.
2- Buying a home and taking on a mortgage
It is really tough to save a significant down payment, usually 20% of the purchase price to avoid PMI, for your first home. I certainly did not do that for the first house I owned. Until just this year, I never even owned my personal home free and clear. I would have a hard time telling anyone they should save 100% of the cost for their purchase so they can pay cash and avoid a mortgage completely.
However, I would recommend that you do save money for the 20% down payment to purchasing a home. This is only if you plan on living in the home for at least 5 years. It is important to determine if you could handle the mortgage payments, in the event of a layoff and that you have enough emergency funds, passive income, or some other work that could replace your lost income.
It would be best to borrow for the shortest time period as possible – with 15 years hopefully as the max loan term. This is advice from someone who has only had 30 year mortgage on a personal home – but has always made additional principal payments. 🙂
3- Health issues
Sometimes things happen that we have no control over. When my youngest daughter was born she had serious issues with breathing that put her in the ICU for 3 weeks. Fortunately we had very good insurance and the $120k in cost resulted in about a net of $7k out of pocket expense to us. It was helpful to have an emergency fund available where we could pay for these deductibles and co-pays.
What happens if you do not have insurance or there is a family member who needs help?
Hopefully you realize how important it is to have health insurance. The number one reason for declaring bankruptcy in the US is due to medical expenses. (The #3 reason is poor use of credit.) A lifetime of your savings could be wiped out by medical bills. It is not worth the risk to go without at least a very high deductible plan, even if you feel you cannot afford health insurance. This is the same suggestion with auto, home, and long term disability insurances. Also don’t forget about life insurance – that is if you have family that relies on your income.
Another good example may be if medical procedures were required for either yourself or a close family member. To me personally it would be worth borrowing money, or setting up a payment plan with the hospital, if you did not have the money to pay for these services and needed them performed immediately. What could be more important than your or your loved ones health?
Life is not predictable and crap happens! If you are truly focused on your personal finances with a passion of retiring before 65, you should have an emergency fund.
Now what happens if you don’t have an emergency fund and some health item described above is required or perhaps you have to fly across the country for a family emergency? What if a parent is dying or in severe health and you need to see them now, perhaps before they are gone forever?
I would think this is a case that would justify using a credit card to pay for a trip and carrying a balance; that is only if you could not pay it off immediately. This might be the last time to see a relative or friend, which in my opinion would be well worth the expense. The same consideration should be considered for funerals of dear friends or close family.
5- Buying investment real estate
There is one last use of credit that I consider an appropriate time to take on debt – that would be buying real estate as an investment. I have built a passive income investment by purchasing residential real estate for the business purpose of leasing those properties to tenants.
This is a classic way of leveraging debt or OPM (Other People’s Money) to purchase an income producing asset. It is critical to do the upfront investigation of the property, carefully analyze the investment return, and allow for multiple contingencies that would include such things as repairs and vacancy rates. (I will definitely get into this as an investment option in future blog posts)
For this type of investment, conventional financing with banks will require 25% – 30% down. The banker will discount the occupancy percentage to allow for vacancies when they arrive at their rental income calculation. Be prepared for that! There are of course other ways of buying real estate without using the traditional bank financing approach and large down payments.
When is debt something we can’t live without?
I described what I felt were 5 categories where it is reasonable to borrow money. When you are young and just starting in your career it would be difficult to purchase a home without years of savings. A medical or other type of emergency could be examples of Murphy’s Law in full force for situations that you might not have been prepared for – but it happens!
I believe that for the majority of those reading, there are only few instances when you should take on debt as a Good debt.
- Student loans: If this is the only way you can go to college and the resulting income you can generate from your work can pay off these loans in 2 – 4 years, then I think this a worthy reason to take on a student loan.
- Your first home: It is very difficult to save enough money to pay cash for your first home. Difficult but not impossible. You are a rare individual if you can do it and I applaud your ability to accomplish that feat! For the rest of us, I think a mortgage is a necessary evil that we should attempt to pay off as quickly as possible.
- A rental property: Again, very difficult but not impossible to pay cash. Paula over at Afford Anything paid cash for her last rental property purchase. That is a great place to be, however just like me, her first purchased was financed too! 🙂
Notice I did not mention it was necessary to borrow money for a car? I certainly have done that with most of the cars I have bought in my lifetime. In most cases I paid them off anywhere from as soon as 6 months to as long as 3 years. If I had to do it over again, I would have only paid cash and invested the difference. This would be an example of a much bigger “Reverse Latte Factor” savings strategy that would have had a big impact on my long term net worth.
Minimize your Good Debt and destroy your Bad Debt
I would recommend that you should avoid incurring new debt for purchases that can be saved for in a reasonable time period. So you want the new big screen TV and surround sound system – right? No problem, just save for it and then charge it on your credit card for the points/miles/warranty, then pay it off in full when the bill arrives. In fact you should have it automatically deducting from your bank account anyway; to avoid paying late, missing a payment, or not paying in full each month.
Consider only taking on debt that shows a ROI. Some examples would be building equity in your personal home, an education, or a real estate investment. The investment real estate is an excellent example of leveraging OPM when you purchase the right property. Of course if needed, borrow for a health or family issue. Do this only if it is really an emergency.
At this point in my life, it is nice to have no debt obligations except for some rental real estate. This helps reduce my cost of living significantly by not having personal debt that goes with monthly principal and interest payments. If you make a similar choice, this will have a major impact on your finances for years to come. It would certainly make it much simpler to reach a point earlier in your financial independence journey as opposed to later, where the amount of your passive income is enough to pay for your current lifestyle!
Can you think of any other categories of debt not mentioned here that should be considered Good Debt? Have you noticed your opinion on the use of credit and debt change as you have grown older and wiser?