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You know I hate debt: Debt makes you poorer, gives you anxiety, restricts what you do, and is a major factor of stress in relationships. However, as much as I detest debt, there are a very few times when it makes sense to incur it.
Good Debt:
House: Face it, you need a place to live and unless mom is letting you sleep in your old room (and not charging you rent), you’re going to have a monthly payment. So if you can buy a house and the monthly fully amortized payment on a 30 year fixed rate loan is about the same or less than renting, then you have yourself Good Debt.
There are lots of online calculators of rent vs. buy that factor in your tax rate, property taxes, maintenance and a bunch of other stuff but realistically, if your mortgage costs are about the same as renting: Buy! And guess what, there are only two factors that determine your monthly mortgage payment, the Price you pay and the Interest Rate on your loan. Check out How to Save a Ton on Buying a House. If prices are too high or your credit stinks and you can’t get a good mortgage rate (sub 5.5% today), then just Rent and save the difference. Read about the Millionaire Renters.
Cashflow Property: Any time you can acquire property with a net rental stream that is greater than the monthly expenses to buy it, you have Good Debt. Why? Very simply if the income stream from the property (typically other people renting) net of all your expenses covers your mortgage, taxes, insurance, and maintenance, you’ve gotten somebody else to pay for your property. Now depending on the timeframe, real estate market and geographic location, this may be difficult to do, but they do exist. Are there risks? Of course: dead beat renters, vacancies, lower rents, the hassle of being a landlord, etc. But if the mortgage is covered by the income you have good debt. And when its paid off, you will have a very nice cashflow and a significant asset (taxed a long term capital gains).
Debt at a Rate < Risk Free Investment: Sometimes the opportunity presents itself to get debt at a rate that is so cheap that a smart, disciplined person can make money on it. Lets take Student Loans that were consolidated during 2004. Due to a once in a lifetime drop in the T-bill rates, certain student loans could be consolidated at a rate of 3.49%. In addition, if you paid automatically and made your first 48 payments on time, your rate was 2.24% for up to 30 years! Given the tax benefits, the effective interest rate was approximately 1.5%. Its hard to get debt much cheaper than that unless you live in Japan. Now at certain times after that, you could have locked into 5 year or longer CDs or other risk free investments at 5%. If you can get debt substantially below the historical risk free investment rate, take it and make money on the spread. But only do this if you plan on investing or paying down other debt with the proceeds.
Not So Bad Debt:
Car Used to Commute to Work: Many people would say, “Go Green, Take the Bus” but that isn’t realistic for everyone everywhere. I was lucky my first 4 years of working, I lived 6 blocks away from work in a major city and didn’t need a car, bus, or train, just the old foot on pavement routine. But if you need a car to get to commute and don’t have the cash, get a sub $5,000 used car that is highly reliable on a short term loan (36 months or less). To save on the cost, check out your local credit union, they tend to have really good used car rates.
Certain Education Loans: The financing of higher education has become nearly criminal in many cases. Dubious degrees costing up to $40,000 a year, financed at exorbitant rates, and fully promoted by the Federal Government. Like everywhere else, financing of education has created a bubble where mediocre product is priced almost as much as the top tier.
Certain educational debt makes sense if it meets the following rule. If the total cost of the education is no more than 3 times the expected annual increase in salary then you have good debt. Some people ask what is so magical about the multiplier 3. Well any education that doesn't pay for itself within 5 years isn't worth it. Given that you are going to incur interest on that education loan and you may have given up some salary in order to pursue that education, 3 is a safe bet.
You might also ask why this isn’t Good Debt. Unlike a house where the comparative rent is known and unlike a cashflow property where there is a rental and expense history, your future is unkown and highly unpredictable. I can't tell you how many people I know that pursued a law degree and borrowed $100,000 over three years, gave up their income for those years and after 1 year of working in a law firm, decided they didn’t want to be a lawyer anymore. When you buy a rental property, your not going to suddenly kick the renters out because you’ve had a change of heart.
Everything Else: Its all bad debt. If you want a 29 foot powerboat pay for it with cash. Luxury car, cash. HELOC to buy an RV, bad idea. Personal loan, really bad idea. Stick to the Good debt and if you have to the Not So Bad Debt and you'll be fine.
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