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.