Good Debt, Bad Debt

The kind you don't mind having can help you produce healthy income. The other kind can leave your finances in the sickroom.

Your Money

February 27, 2005|By Novelda Sommers

THERE CAN be a wide gulf between having wealth and looking wealthy.

If you have many of wealth's trappings but are drowning in debt, you might want to check the health of your finances, says Jon Hanson, author of Good Debt, Bad Debt: Knowing the Difference Can Save Your Financial Life (Penguin, $21.95).

Not all debt is bad, he argues. It's like cholesterol: There's one kind that improves your health and another kind that makes you sick.

Good debt helps you gain assets that produce income. If taking out a loan will put you in a better financial position, it's probably good debt. Bad debt lays claim to your cash but doesn't produce cash flow. It's money borrowed for something that loses value. "Zero debt is the ultimate goal," Hanson said. "But never having debt makes it hard to accumulate wealth."

The bad kind leaves you unable to eliminate debt because of insufficient cash flow, he says.

Many Americans have so much of the bad kind of debt that they can't get the good kind. Nonmortgage consumer debt reached $2.1 trillion last year, the Federal Reserve reported recently. That's $17,530 per household, up from $16,035 the previous year. The average car loan last year was for $24,888 and five years.

Hanson said he learned the hard way about debt years ago after running up more than $90,000 in delinquent taxes and fines while selling real estate.

"I was making a lot of money, but I didn't put enough aside for the IRS," Hanson said. "I ended up selling some assets and paying that off."

Good debt includes:

Real estate loans. Mortgage lenders generally will allow you to put 29 percent to 41 percent of your income toward housing expenses. But many consumers can't get mortgage loans because consumer debt has eroded their disposable incomes and credit ratings.

Property is a good investment if it gains value, Hanson said, but most homes are not technically producing income, as an asset purchased with good debt should be. Mortgage debt is good debt for buyers who find bargains and garner equity quickly, then use that equity to buy their next house in a few years.

Loans to finance income-producing rental and investment property also are good debt if the borrower turns a profit.

Student loans. An education pays for itself, according to the College Board, a nonprofit association of more than 4,700 schools, colleges and universities. Over their careers, college graduates earn 73 percent more than high school graduates, and advanced-degree holders earn two to three times as much as those with high school diplomas.

In 2003, the average full-time worker with a degree earned nearly $50,000 a year, 62 percent more than the $30,800 average for the full-time worker with a high school diploma.

The cost of a four-year education, including tuition, fees, room and board at a public university, averages $11,354 a year and is climbing.

Bad debt includes:

Car loans. Many buyers don't realize they're choosing the smell of new leather over retirement. Hanson uses the example of a 31-year-old paying $599 a month for a luxury car instead of $300 a month for a less flashy one. If the buyer had selected the cheaper car and invested the difference over 34 years, he could end up with more than $1 million at age 65.

Most new cars depreciate 20 percent in the first year and in smaller increments each following year. Car buyers can find themselves paying installments on loan balances higher than their cars' worth.

It's usually better to buy used and let the first owner pay for those expensive first years, Hanson said.

Credit card debt. If you carry a balance from month to month, you're paying more than the sticker price for things that are probably losing value.

Making a minimum payment of 2 percent per month, it would take almost 31 years to pay off an $8,000 balance on a card charging a 13 percent annual percentage rate, according to Cardweb.com. Also, you would have paid nearly $9,100 in interest.

The first step to paying off debt is to stop spending more than you bring in, said Robert Gerstemeier, a certified financial planner in Naperville, Ill. It's sometimes advisable to get a low-interest loan or home equity line of credit to pay off high-interest consumer debt, he said. While you're paying off that loan, the consumption has to slow down. Gerstemeier recommends that certain clients consider consolidating debt from high-interest credit cards onto one lower-interest one, taking advantage of cards offering zero- or low-interest introductory periods, even if it means transferring balances as those special offers expire.

Novelda Sommers is a staff writer for the Daily Press, a Tribune Publishing newspaper in Newport News, Va.

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