Monday, March 30, 2009

Debt can be good

On Mondays, we answer a question from a reader in this space. If you'd like to ask a question, post it in the comments or send it to us on Twitter @family_finances.

QUESTION: I’ve heard you mention that there’s good debt and bad debt. So, what do you consider to be good debt, and what’s bad debt?

ANSWER: “Neither a borrower or lender be,” Shakespeare wrote in Hamlet more than four centuries ago. And it’s become a sort of holy middle-class mantra. But there are different kinds of debt, and not all debt is bad. Borrowing for consumer goods is almost always bad. Borrowing to buy a nice house in a nice neighborhood is almost always good.

Debt should be used sparingly and conservatively, and only for items that keep or add value over time. Most of us need to borrow for houses and cars, at the very least. Both of these items have such large price tags that few families can pay cash. It's not so bad, though, because both retain value over time. Houses more than cars, of course, but even cars will hold some value - with proper maintenance - after the loans are paid. Most other items - furniture, electronics, boats, motorcycles, and consumer goods - lose most of their value as soon as you buy them. Having a big loan outstanding against things lacking resale value is the absolute worst-case scenario in personal finance. Use debt wisely!

Many quality wealth advisors recommend against paying off a mortgage early, and there is documented evidence supporting this approach. Nevertheless, many middle class folks want to “pay off the house” as quickly as possible. They think they’re doing the right thing. But, money for paying down a mortgage comes from somewhere, and it’s no longer available to invest. That can be counterproductive to long-term growth. Our wealthy friends understand the difference between good debt and bad debt.

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