Good Debt vs. Bad Debt
- Student buy non-essentials more often than other groups
- There are different types of debt
- Being responsible with debt will result in long-term benefits
A friend in the banking/investment industry summed it all up: good debt is an oxymoron; there's no such thing as good debt.
However, while debt may be something we all wish could be avoided, there are some forms of borrowing that do have advantages, and even those that are considered bad debt can be useful if used properly.
Background on Student Debt
First and foremost, student loans should be utilized for education and required living expenses only. Trends in college student spending indicate a rise in non-essential expenses.
Pricegrabber.com, in conjunction with Rand Youth Poll and Campusmag.com, issued a 20-year study showing trends in student spending. Basically, the results showed that students are more technologically savvy than 20 years ago.
Spending has increased in the area of entertainment with large plasma TVs, cellular phones and iPhones with all the bells and whistles, and iPods with subscriptions to download music and DVDs.
Other increases are clothing costs for designer clothing and the emergence of gourmet coffees and other specialized foods.
As a result, students (not just the 18- to 21-year-olds, either) are easily drawn into borrowing extra student loans to purchase extravagant tangible and intangible goods.
The key to good borrowing through student loans is to set up a budget and resist spending on unnecessary items. There's time for purchasing nicer items after graduating.
"Good" Debt
- Student loans
- Home loans/Mortgage
- Business loan
Loans to Pay for Education
Is a student loan really a bad thing? Not necessarily.
If it's necessary to borrow a student loan, consider the process of value because it's investing in an education. U.S. Government Info through About.com identifies a substantial increase in lifetime income for student with an advanced degree over a high school education.
A high school degree brings an average lifetime income of $1.2 million, while a bachelor's degree brings $2.1 million, a graduate degree $2.1 million, and a professional degree $2.5 million (Source: U.S. Census Bureau. So really, you are building equity in yourself. Not to mention, your student loan payments can now be deducted up to $2,500 on the federal tax return.
A Home Loan
A home mortgage loan can be a good debt for independent students who own their own home or the parents of dependent students (owning their own home) who consider borrowing through the federal PLUS loan.
Mortgage loans can be considered good debt because the interest for money borrowed in a mortgage is tax deductible. Itemizing home mortgage interest rates is one of the few remaining itemization options on the federal tax return, and personal residences are almost always the lowest interest rates of all. Currently, 15 year mortgage rates average 5.75%, while 30 years mortgage interest rates average 6.00%.
Business Loans
As with a home mortgage, business loans are another source of borrowing that allow tax deductions. In addition, a home mortgage or business loan is an investment that creates value; therefore, it is considered a good debt as long as it's not rolled into an existing long-term loan.
Try to keep a second mortgage or business loan at a shorter repayment period than the initial mortgage or startup loan. If not, at least try to pay more than the minimum monthly payment to pay the balance off early since any extra payment to a mortgage loan goes directly to the principle.
The rule of thumb to remember with mortgage or business loans: take only if using funds to improve or increase equity.
However, even though home mortgages may be a viable option, it is still an advantage to borrow through the Subsidized Loan program before taking out a mortgage or second mortgage because Subsidized loans defer both payment and interest while the student is in school.
Repayment terms are usually shorter (10 years) than a mortgage or business loan, so even though the student loan has a higher interest rate, the difference between paying a 10 year student loan versus interest on a 15 year mortgage loan may end up being relatively the same amount.
Remember, both mortgage interest and student loan interest can be deducted on the federal tax return, but there are qualifications to both. It's important to consult a tax preparer to see from which, or both, types of loan you may benefit.
"Bad" Debt
- Credit card debt
- Car loans
Credit Card Debt
Unequivocally, credit cards are considered mostly bad debt. David Bach, CEO of Finish Rich Inc., reports that the average credit card debt for American consumers is $8,400.
While VISA and Mastercard may offer lower interest rates (ex. 9.99%), many private organizations and department stores have exorbitant interest rates (ex. 24%) attached to their credit cards.
If the balance of any credit card is not paid in full during the first statement, interest will accrue and continue to do so at a daily rate until the balance is paid.
Playing the "shell game" with transferring balances to a lower and interest-free credit card doesn't always pay off, especially if there is a transfer charge, and the interest rate is higher after the initial interest-free period. Also, having too many credit card accounts open could hurt your credit score or affect lending approval at a bank.
Bottom line: if a credit card must be used, always pay the balance off each month. If you follow this rule, a credit card may not be such a bad debt, as you are building a credit history.
Car Loans
Another loan considered as bad debt is an auto loan, mainly because it's a tangible item that does not appreciate in value, only depreciates over time - for example, the second you drive it off the lot!
Lenders and loan companies now offer up to 72 months to pay off an auto loan in certain situations, which means interest is accruing for a much longer time.
Understandably, a vehicle is considered a necessity for most people to travel back and forth to work. Weigh the options of different interest rates and repayment periods to see which is more beneficial.
For example, if a new car offers 0% financing but costs more than a used car with a high interest rate, have the dealer or bank figure payments and interest on both and choose what's most beneficial and reliable.
Middle of the Road Debt?
Private Loans to Pay for Education
With regards to private educational loans, proceed with extreme caution. Why?
Private educational loans are not federally regulated like the Stafford loans and Direct loans, meaning interest rates, fees, and repayment plans can vary greatly. Students are usually deluged with marketing materials from lenders, and it's often difficult to wade through every piece of correspondence to find the hidden charges in the fine print.
The Department of Education announced that their Office of the Ombudsman is putting together a task force to investigate the questionable marketing practices of private student lenders because they have come under such public scrutiny.
Private educational loans are much like the Unsubsidized loans where with most loans the interest accrues while the student is in school, but the principle is deferred until after graduation.
However, most private educational loans do not have the federal limits of the Subsidized or Unsubsidized loans, and students can borrow up to their student budget. So why is that so bad?
Students often borrow more than is needed to pay their university bill or living expenses. Also, interest rates are usually higher for private educational loans than federal student loans. Private loans may promote a desirable interest rate with their marketing, but the fine print may say otherwise.
An example is a lender who advertises a relatively low interest rate, but when the student applies he's told the actual interest rate is much higher unless he has a cosigner.
Not all private lenders are alike; there are reputable companies out there. While a private educational loan is still a debt toward investing in your future, it's important, even critical, to read the fine print on all materials prior to completing an application.
Students with a good credit rating, valid cosigner, credit history, or other positive aspect, may find a private educational loan to be competitive with other financing resources.
Summary
Debt is the responsibility of the borrower. There are preventive measures which can be taken to avoid some debt, such as setting a budget or saving for a purchase.
However, debt can be good is used for the right reasons. Debt used to increase value long-term can be considered good debt.
Using borrowed money to pay for disposable items or tangible goods that decrease over time is considered a bad debt. Although this article separates good and bad, any debt mentioned here can be good debt if used properly.
Terri Hare is a senior financial aid administrator with nearly 25 years experience in the profession. She completed both her bachelor's and master's degree as a non-traditional student, with a family and full time job. Her master's degree in Instructional Design and Technology was completed primarily with online courses, so she's familiar with the intricacies of balancing family and distance learning.
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