Good Debt, Bad Debt?
by Tom Kirk
How much debt should you carry and what kind? Here are some guidelines from our wealth services firm in Melbourne to help you make these tough decisions.
The best kind of debt to have (if you are going to have any debt at all) is the long-term, fixed rate, tax-deductible kind. Long-term because you can always shorten it by accelerating payments, but cannot extend it without refinancing; fixed rate because interest rates are at a historical low and you can lock in now for the entire term of the debt; tax deductible because the tax benefits reduce your interest cost. This kind of debt usually appears as a home mortgage.
The worst kind of debt to have is the kind where the interest rate is high, it varies month to month and is not tax deductible. Most credit cards are like this. Use these only as a convenience to batch your purchases and pay these off in full each month. Never incur credit card interest if possible.
Other consumer debt (like car loans) is somewhere between the best and worst kind of debt. It usually has a fixed, low interest rate (good) but is not tax deductible (bad). Be sure you get the best price for the vehicle first. Sometimes the purchase price is higher if you take advantage of discounted financing, effectively increasing your interest cost.
How much debt can you afford to carry?
General guidelines that banks used to use were as follows: your home mortgage principal, interest, taxes and insurance (PITI) should not exceed 20 percent of your gross income; and your total debt payments (including car loans and credit cards) should not exceed 25 percent of your gross income. However, in the recent past banks have lent money far in excess of these limits to individuals, allowing people to purchase homes and cars they could not afford and contributing greatly to the economic melt-down of 2007-2009 which we now call “The Great Recession.” So even if a bank will lend you more than these limits would suggest, don’t do it. You may be “house poor” at best and may lose your home through foreclosure at worst.
Most people cannot avoid using debt of some kind to help them accumulate assets during their working years. The kind and type of debt you use can make all the difference whether or not you achieve your financial goals.
Call our wealth services firm in Melbourne today and speak with one of our WealthCoaches™ to see if we can help you create the life you dream about.