A battle constantly rages in the war that is our consumer driven society. One on front, we find the extremely well armed and financed usurers, disguised as friendly banks, mortgage companies, credit card companies, auto dealers, and just about any retailer. Don't worry about the price, we can help fit the monthly payment into your budget. No need to make any payments until next year. Trust us, we're here to help! With their endless databases of consumer behavior (specifically yours), access to credit histories, and decades of a hard fought marketing arms race, there is no enticement they can't offer to gain access to your wallet.
On the other side of the battleground, exposed to direct fire from all sides, are financially under-educated consumers. Their only defense? A few radio talk show consumer advocates (who never ask enough questions to give sound answers to their callers), a completely underwhelming financial education in schools, and a variety of underfunded and overwhelmed consumer protection agencies. With such limited direction, many consumers simply follow in the footsteps of their main role model, the federal government.
What to do? Is all debt bad? Should we regress to an agrarian society where trade is conducted via barter? Of course not. Credit is not all bad. Used correctly, credit facilitates commerce by allowing for easier transactions and control of payments. It is the abuse of credit that is the root of much evil.
So what is good debt? There are a number of metrics to consider when evaluating whether a proposed debt is good or bad. The first part of the equation is quantitative: Will the asset I purchase appreciate (go up in value - like a home) or depreciate in value, like a fancy outfit, or even be consumed, like a meal. If I have to pay interest, can it be tax-deductible or not? Is the interest fixed or variable, and where are current interest rates in historical terms? If I had to pay the debt off early, would I have the resources available?
The second part of the equation is qualitative: do I really need this, and do I need it now? Can I wait another six months and pay cash? Am I generally a risk averse person who doesn't like debt, or am I comfortable with leverage? Is my financial house generally in order? Am I taking on this debt because it's the most efficient method of payment and financing? Is this a good decision for my balance sheet?
Generally speaking, taking on a reasonable amount of tax-deductible fixed rate debt to buy an appreciating asset is good (e.g. a mortgage). Taking on non-deductible variable rate debt to buy a consumable item or a depreciating asset is bad (e.g. a credit card). Everything else is in between and should be considered on a case by case basis. Some examples follow.
Buying a new car that you can actually afford at 0% (or 1 or 2%) is probably ok, assuming you're not accepting an artificially high sales price that offsets the finance savings. Using the lower payment to justify a more expensive model is probably a bad idea.
Buying furniture you can afford with no payments until next year and paying off the balance before it's due is probably ok. Doing the same thing on furniture you can't afford and not paying it off on time is a bad idea.
Refinancing your house with a short term adjustable rate mortgage because you are absolutely positively being transferred in two years and your company is handling the relocation (and thus buying your house) is probably a good idea. Using a short term adjustable rate mortgage to buy more house than you can afford on normal fixed rate is not a good idea.
Correctly managing the liability side of your personal balance sheet is just as important as managing the asset side. Most "normal" upwardly mobile families carry far more liabilities than investment and retirement assets for the first part of their professional lives. Put simply, student loans and mortgages start with high balances while retirement and investment accounts start low. It's often a decade or more before the lines cross. Mistakes in managing the amount and structure of personal debt can easily overpower great decisions made in investment or retirement accounts. Keeping a close watch on both sides of the balance sheet does not guarantee success, but it certainly helps.
As always, we encourage you to use Freedom Wealth Partners as a resource before you make any major financial decision. While we are not experts in every field, we have helped clients shop for new cars and boats, helped decide how much house to buy (and where), reviewed college decisions, and even evaluated business deals. If you have any questions or concerns before your next big decision, feel free to call or email anytime.
Kary Brownlee, CFP®