Reader Question: Does "Good" Debt Equal "Good" Interest?
Posted on January 10, 2007 by Her and tagged debt, interest
Reader A asks,
Some kinds of debt are good I heard.. like the interest we pay on mortgages and student loans. Is this true? Are you better off paying as you go on these so you get some deductions at tax time or should you pay these off as soon as possible? (I know the interest we pay on car payments and credit card bills is not deductible.)
Thanks for asking, A! Here's what we think.
"Good Debt" vs. "Bad Debt"; What's the difference?
"Good debt" is generally considered to be an investment in who you are and who you will become, so mortgages and student loans are typically considered "good debt." "Bad debt" comes from paying for today's wants with tomorrow's cash, thereby jeopardizing your ability to meet your future needs. Think credit card debt.
Interest Deductions and Taxes
Both good debt and bad debt accrue interest. There is no such thing as "Good Interest." While tax deductions help minimize the hit on your wallet, no tax deduction will ever completely offset the interest. Let's use student loans for a simplified example. Let's say you borrow $5,000 at 5% to get a degree in order to qualify for a promotion and a pay raise at work. That's good debt. After the first year of repayment, you have paid about $250 in interest. At tax time, you are allowed to deduct that $250 from your gross income. In essence, the government pretends that you never earned that $250 and therefore do not owe taxes on it. If you are in the 25% tax bracket, then you will owe $62.50 (25% of $250) less on your taxes. So this year, you will have spent $250 and saved $62.50, resulting in a net loss of $187.50. On the other hand, that promotion and raise allowed you to earn an extra $1000 this year, which greatly outweighs the cost of the interest. (For the details of this please refer to this IRS publication)
I'm not sure how this works for mortgage interest since we don't currently own a home, but think it works somewhat along the same lines.
So when does it make sense to incur good debt?
You should never incur any debt for the sole purpose of reducing your taxes*. There are plenty of better ways to reduce your taxes, such as saving for retirement in an IRA or 401K, donating to charity, or taking advantage of flexible savings accounts offered by your employer. However, it does make sense to incur good debt when you can reasonably predict that incurring the debt now will allow you to earn more money later. In the case of student loans, most students graduate with about $20,000 in debt. But a college degree can boost your income over a lifetime by as much as $1 million! This makes a college degree worth the initial expense.
But even good debt shouldn't be your first choice...
Debt and interest have to be repaid. There are often better ways to achieve your goals than by accruing debt. Options include deferring your purchase to have time to save money; or looking for other sources of funds that don't have to be repaid, such as grants, scholarships, or first-time home buyer programs. And any time you incur debt, you should always try to minimize both the amount you borrow and the interest rate you pay.
The Bottom Line
If you can reasonably predict that getting a degree or purchasing a home will increase your future net worth, then it may be worthwhile to incur good debt. But first you should look at other options, and know that there's no such thing as "Good Interest." If you must incur a debt, your best option is to pay it off as quickly as possible.
*Is there an exception?
There are exceptions to every rule, and you may have heard of people who strategically make only the minimum payment on a mortgage in order to achieve a complicated tax strategy. Generally, this is a solution only for those who are in a very high tax bracket, who have exhausted all other means of reducing their taxes, who have favorable mortgage interest terms and are investing an equal or greater amount of cash in a high-interest investment. Even then, this strategy is risky and should only be undertaken with help from a certified financial planner.
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Neal | Jul 23, 2007
Your comments are dead on. There really is no good interest, especially under the rules the lenders place on the loans. Much like the gaming world, the house will win the majority of the time. 'Do you feel lucky... well do ya punk?'
We will all incur debt and pay interest unless we live in an Amish community; the trick is to eliminate it as efficiently as possible with the greatest savings of time and money. Any of your earnings that are not used to pay interest will ultimately be left for asset accumulation (wealth) that is 100% yours. After that it becomes about your ability to manage your wealth, which most people will do with much greater efficiency than they will manage debt. Wealth is something most folks want to protect; debt is unfortunately accepted as status quo and 'managed' with minimum payments. Either way, the services of a professional go a long way for the average person or family who isn't going to learn and apply every little intricacy of financial management.
moom | Jan 10, 2007
Mostly good advice that a lot of people should heed but don't. I'd put it more strongly:
"Never incur a debt just to "save" on taxes. No exceptions".
Any tax deductions allowed just reduce the real cost of the debt. I don't know of any program where the government gives you a credit exceeding the interest paid.
OTOH if the interest is low on an after-tax basis and you are investing the proceeds in an investment that yields a lot more return than the cost of the debt it can make sense to borrow and one shouldn't be in any hurry to pay off the debt. But don't take on so much leverage that it endangers your financial health in the case of an upset in your investment plan.
Where things get complicated is that debt is "fungible". If you have a tax deductible mortgage on a house, you can invest the cash that you would otherwise have sunk into the house into something more lucrative. You need to look at the whole portfolio not just the asset the debt is nominally paying for.
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