Wednesday, October 26, 2011

Good Debt Myth Debunked

Prior to the Great Recession, a common rationalization was to categorize debt as either good or bad.  Good debt was OK to have have.  Bad debt was not. People typcially put home mortgages and student loans in the category of good debt.  Car loans sometimes were good debt.   Credit card balances and payday loans were typcially bad debt.

However, the Great Recession has made even good debt look pretty bad.

  • Home mortgages.  This type of debt used to be the epitome of good debt.   Homes were appreciating assets.   Mortgage interest was subsidized by tax deductions.  Mortgage payments increased equity while rent payments were considered wasted.

    However, since the 2006 peak, home values have plunged 31%.  25% of homeowners have underwater mortgages where the value of the mortgage debt is great than the value of the home.  Mortgage interest deductions have low value when mortgagees can no longer make the payments.   In many areas, rents are now much lower that the mortgage being paid on similar properties.

  • Student loans.  This type of debt used to be justified as an investment.  College graduates earn about 60% more than high school graduates on an annual and lifetime basis.  In 2008, those with bachelor's degrees averaged $55,700 versus $33,800 for those with only a high school diploma.

    However, the high cost of a college education makes it more difficult of graduate to get a return on the investment.  With the cost of a top private college education exceeding $200,000, it would take 10 years at the higher paying job to recoup the cost of attending college.  Add to that the cost of repaying student loans used to finance the college education.   That's assuming the graduate can get a higher paying job, since only 51% are starting in jobs that require a college degree.

  • Home mortgages and student loans are no longer viewed as good debt.    Now they are just debt, as they always should have been.   As with any debt, home mortgages and student loans need to managed prudently to ensure they don't become a financial burden.
    For more on The Practice of Personal Finance check back every Wednesday for a new segment.

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    This is not financial or debt advice. Please consult a professional advisor.

    Copyright © 2011 Achievement Catalyst, LLC


    Kim said...

    I agree with you that the title of "good" debt is somewhat misleading, but student loans (perhaps) and housing loans are infinitely better than consumption debt.

    Financial Independence said...

    In the current climate there is no insentive to save the money. I recently did some calculations and the results are very much frustrating, to be brutally honest. Have a look yourself - they are all published.

    If you invest $ 40, 000 a year over 35 years, at modest inflation rate of 2% and administration fee of 1-2% you need stock market to perform at 4% just to preserve value of your money and higher to gain anything.

    This means that you are only preserving money you are investing at a very high risk. So it is just plain wisdom - is there a point to be frugal and try to save, if you ended up loosing money?

    Feeding financial industry or living your life in full now?