Good Debt and Bad Debt: Why You Need a Plan
When many people think about debt management, they envision a debtor struggling to pay their bills each month. But debt management plans are a smart move for everyone, whether they can easily make the payments or not. Why? Here are a few key reasons.
1. Not All Debt Is Bad
Debt management doesn’t mean avoiding all debt. Debt can be quite useful. It allows you to purchase assets or embark on new endeavors that grow your net worth. When used properly and with a goal, this type of good debt improves your life and finances.
What kind of debt can grow your net worth? This includes borrowing to earn a degree that increases your income potential. It may involve buying real estate that will appreciate in value. Or it could be borrowing to start a business with the potential for income for many years.
2. Not All Debt Is Good
While some debt has its uses, other debt creates problems. The biggest often comes from high interest rates. Borrowing money at a high rate makes the money expensive. If you borrowed in order to avoid tying up money that could be invested, a high borrowing rate cancels out these benefits. Revolving debt can be another problem, as it masks financial problems that may eventually become unsustainable.
Finally, debt may be bad if your finances are overly leveraged and at risk. Car loans, for example, allow a person to buy the vehicles they need to earn income and get around. But the car is worth less and less each year. So, many auto loans are higher than the asset is actually worth. This makes your finances less stable because you would still owe money even if you sell it or get an insurance payout.
3. Planning Maximizes Potential
The best way to approach debt usage is with advance planning. How much debt is good in your situation? Many mortgage lenders define this as no more than 36% of your income. But if that number includes a large amount of high interest revolving debt, the result isn’t particularly good for your finances.
Debt management plans look at the big picture to determine how to deploy good debt and how to minimize bad debt. By getting rid of credit card usage, for instance, you might free up funds to take on low-interest student loans to get a higher degree or qualify for a low interest mortgage on appreciating real estate. The total percentage of debt might be the same, but you’ve traded bad debt for good debt.
4. Debt Management Varies Through Life
Many aspects of your finances change over time as your needs and wants change. A young investor, for example, should usually take on more risky investments in retirement accounts to speed growth because they don’t need to access that money any time soon. But as they age, the investor generally reduces the levels of risk and seeks more stability.
Similarly, your debt needs and strategy changes during different periods of life. When your earning power is growing, it may be wise to take on debt to buy real estate. But most retirees eventually choose to limit their mortgages and credit lines to protect their asset and reduce monthly obligations.
Your debt management plan, then, should take into account these factors. It may need reassessed when a life change occurs and on a regular schedule.
5. Your Planner Can Help
If you want to use debt strategically, your first step should be to meet with a qualified financial planner or wealth manager. This professional will assess your goals and your resources to find the best balance between good debt and bad debt — as well as between assets and liabilities. Learn more by making an appointment with the pros at Monheit Frisch Group PLC today.