When it comes to debt, the mantra from some in the financial services industry is “all debt is bad.”
This viewpoint is often too simplistic. The fact is, not all debt is created equally, and some debt may even be beneficial—so beneficial, in fact, that it can sometimes be a good idea to maintain some debt rather than immediately paying it off.
It’s important to recognize that there is inefficient debt and efficient debt. As a general rule, we agree that inefficient debt (typically consumer debt) does more harm than good in a person’s financial plan and should often be paid off as quickly as possible.
The reasoning for this is twofold. First, carrying inefficient debt offers no financial advantages. You aren’t benefitting by carrying debt on a credit card—there is no tax deduction, nor is the item purchased likely something that will appreciate in value. Inefficient debt is simply preventing you from doing more efficient things with your money.
The second disadvantage is that consumer debt often carries a fairly high interest rate. The average APR on credit card debt is currently around 12-15%, and it’s not unreasonable for someone with poor credit to be charged at interest rates of upwards of 20%.
To put this number in perspective, ask yourself the following question: How much do I expect to earn on my investments over the long term? 4%? 6%? You may be able to earn upwards of 7-8% if you have an especially aggressive allocation, but it is highly unlikely to earn a rate of return on your investments that can exceed the rate you’re being charged on your consumer debt. The result is that if you aren’t focusing your financial resources on quickly paying off this high-interest debt, you are essentially losing money over the long run.
In contrast to inefficient debt, efficient debt is often okay for you to accumulate, assuming that you have the financial wherewithal to pay it off over time.
Efficient debt has four primary characteristics:
- Efficient debt typically has a lower interest rate than what you can reasonably expect to earn on your investments.
- Efficient debt is used to purchase assets that will likely appreciate in value. This includes the cost of education that can help you increase the personal income you can demand in the professional marketplace.
- Interest payments may be tax-deductible.
- Amortization is allowed if payments are made over a long period of time.
What debt would qualify as “efficient”? The most common form of efficient debt would be interest on a mortgage. This is often the biggest tax deduction for many families, and it provides an effective vehicle for purchasing the single largest investment many families will make. College loans or the loans needed to open up a business could also be considered efficient debt.
Remember: It’s challenging to live out your entire life debt-free, and it may even be economically inefficient to strive to do so. Owning a home, achieving an advanced degree or opening a business are worthy goals that can benefit you financially in the long run but are oftentimes too expensive to pay for out-of-pocket.
The key to managing your debt isn’t to avoid it entirely—it’s to make sure that any debt you take on will help benefit your finances, or your quality of life, over the long term.
This article originally appeared in the St. Paul Pioneer Press on July 12, 2015. You can read the original article here.
