Good Debt, Bad Debt

Over the past year, interest rates have increased due to the Federal Reserve’s tightening. Their goal is to cut inflation to 2% and to do so, they are slowing the economy. For instance, the average 30-year mortgage rate was 3.22% in January. The most recent 30-year fixed mortgage rate is 6.57%. This means for the median State College home purchase of $466,800 with a 10% down payment ($46,680) for a mortgage of $420,120 the monthly payment went from $1,821 to $2,675 a month without real estate taxes included. With the increase in down payment and monthly payments, fewer people can afford that home and, theoretically, that should slow the housing market. It works the same for business loans and car loans: as financing gets more expensive, less gets done.

With interest rates increasing, it’s a good time for a gut-check on debt. There is good debt and bad debt. Even good debt can be bad in too large quantities. 

Good debt has the potential to increase your wealth and/or help you achieve goals. For instance, a mortgage allows you to purchase a home. While you get the advantage of living in your home, you also are slowly eliminating the debt by paying the monthly payment. The average national home appreciation is 5.7%. Keep in mind that local increases may differ and supply and demand can alter this percentage. Over the last five years with low interest rates, the annualized rate was 16.8%. This is very healthy debt as you are growing your net worth by paying down the debt and the asset backing the debt is appreciating.

This debt can be bad if you bite off more than you can chew. To be able to afford a home along with other essentials, housing expenses should not exceed 28% of your monthly income. Housing expenses include mortgage payment, real estate taxes and home insurance. In addition, don’t let mortgage monthly debt payment be more than 36% of total debts; total debts include mortgage, credit card, auto and student loans.

Student loans are sometimes essential to prepare you for the career you want in life. With higher education, you may not build net worth (quite the opposite) but you are building human capital. Human capital is the knowledge, skills and health that people invest in and accumulate throughout their lives, enabling them to realize their potential as productive members of society. You can take this too far also. Look at the numbers: Can you go to a less expensive university, community college or trade school to do what you want?  

Car loans tend to be a necessity with the price of cars increasing. An option is once a car is paid off, put the payment in savings for a down payment on the next vehicle. When buying, consider used cars, which can be less expensive. Shop around for a loan when purchasing your car. The bank you use may provide a lower rate than the car dealer. Again, it’s not worth going into debt to buy the car of your dreams. Experts suggest not spending more than 10% of your take-home pay on a monthly car payment.  

As far as credit cards, just don’t. Rates on these can be incredibly high, as much as 27%. The key to avoiding this damaging debt is paying the total off each month. To avoid putting emergency expenses on these and running up the total, create an emergency fund before the money is needed. Every month sock away a portion of your take home pay in a savings account. If you have high-interest credit card debt, make a plan to pay it down.  

While debt helps us achieve our goals, it has a downside. With our instant gratification culture, it may be difficult to pass up that expensive vacation or hot car; however, saving and growing your net worth until you can afford the finer things can be even more satisfying and better on your bottom line.

Judy Loy is a Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc. in State College.

All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice.  Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.