Good Debt vs. Bad Debt
Understanding the difference
Certain types of debt can be used as financial tools to provide opportunities, such as a mortgage or a student loan. But even though a particular type of debt seems to work in your favor, it may not be the right choice.
To make smart decisions about if, when and how much to borrow, you need to understand how to manage debt and make it work for you.
Debt that can work for you
To work for you, debt should ideally be low-cost and have potential tax advantages. Here are two types of debt that can work for you and why.
- With mortgages and home equity lines of credit, you're borrowing to own a potentially appreciating asset, and it may be tax-deductible. You can deduct the interest on mortgage debt of up to $1 million on your primary and/or secondary residence, whether the loan is to purchase the home or make major improvements. The same is true on up to $100,000 of home equity debt such as a home equity line of credit, which can be used for any purpose. (As always, be sure to check with your tax advisor.)
- With student loans, rates are comparatively low, and interest can be tax-deductible, depending on your income. Benefits include enhanced career opportunities and increased earning potential.
Our Two Cents
Debt that can work against you
Generally speaking, try to avoid debt that is high-cost and isn't tax-deductible, such as credit cards and auto loans. Why? For the following reasons:
- It usually carries the highest interest rates.
- It can be the most costly over time.
- It means you're borrowing to own something that depreciates, so you're immediately losing value. Think of what happens when you drive a new car off the lot!
How much debt is too much?
An industry rule of thumb suggests that:
- No more than 28 percent of your pre-tax household income should go to servicing home debt (principal, interest, taxes and insurance).
- No more than 36 percent of your pre-tax income should go to all debt: your home debt plus credit card debt and auto loans.
Our Two Cents
|Consider These Guidelines to Help You Manage Your Debt|
|If Your Debt Is ...||Then ...|
|Less then 30% of your pre-tax income||You're in great shape!|
|Between 30% and 36%||You're OK.|
|Between 36% and 40%||Beware, you're on the borderline.|
|More than 40%||Red Flag warning!|