Unhealthy debt, such as revolving credit and predatory loans, can make it much harder to reach your long-term financial and retirement goals
Healthy debt, such as mortgages and student loans, can increase net worth, but too much can impede your goals
A financial pro can help you set your debt management strategy for financial and retirement planning
It’s the ultimate paradox, isn’t it? Debt can be a key component of your investing plan, but it can also limit your ability to invest. It can prevent you from making progress toward your goals, but it can also help move you in the right direction toward them. Sometimes, it feels like an anchor around your neck. But sometimes, it lets you breathe a sigh of relief.
The difference? As the old song goes, it’s in the way that you use it.
You’ll often hear financial pros talk in terms of “good debt versus bad debt,” with “good” debt describing things that aim to build your net worth or help you increase your lifetime earnings—think home mortgage, business loan, or student loan. “Bad” debt would be borrowing that goes toward a depreciating asset such as a luxury item, or any debt that carries a high interest rate—like a payday loan or a high-interest credit card.
But framing debt in terms of good versus bad might not tell the whole story. Another way to look at it would be useful versus costly debt, or better yet, healthy versus unhealthy debt. Refer to the table for some of the classic categories of debt.
A Wellness Screening for Your Debt
Doctors and nutritionists like to frame food choices in terms of good versus bad. There’s good and bad cholesterol, good and bad carbs, and even good and bad types of fats. But when consumed in excess, even the good stuff can negatively affect your health. Yes, there can be too much of a good thing.
In economics, we call it diminishing marginal utility—for each additional unit added, the extra benefit is less and less, until you reach the unit that actually does more harm than good.
Case in point: your mortgage. Borrowing to finance a home can be a good thing because historically, home prices have appreciated over time. Sure, you pay interest on a home mortgage, but the interest is usually tax deductible, which means you save on your tax bill from Uncle Sam.
Plus, assuming it’s your primary residence, you save the opportunity cost of renting a home or apartment. However, buying more house than you can afford can make you cash-poor and thus vulnerable to a cash squeeze that might force you to max out a credit card or take out a payday loan.
A student loan is another classic example of healthy debt that can become bad for one’s financial health above a certain level. Sure, it’s an investment in your education and therefore the potential for higher lifetime earnings. But a number of studies point to student debt as a major reason millennials may delay buying a home, saving for retirement, or working toward other long-term financial goals. Prior to the COVID-19 pandemic, the average student loan payment was nearly $400 per month, according to Federal Reserve data. That can certainly leave a dent in one’s savings plan.
On the other side of the ledger is bad debt. And bad debt is pretty much always unhealthy. Payday loans, title loans, and other so-called predatory loans can put borrowers in a debt trap from which it’s nearly impossible to escape. Even the ubiquitous credit card—if the balance isn’t paid off in a timely manner—can quickly get you in over your head.
But what about auto loans? Loans on depreciating assets such as cars and boats are usually categorized as “unhealthy,” but really, auto loans can be argued either way. On one hand, reliable transportation can be important for your job security and advancement. On the other, a car tends to drop in value the minute you drive it off the lot. For auto loans, and for any loan, really, it’s important to negotiate the lowest interest rate for the shortest borrowing time.
And again, if you buy more than you need, the debt shifts from healthy to unhealthy. There are work trucks, family haulers, and “point A to point B” cars, and then there are luxury SUVs and exotic sports cars.
With your money as well as your health, moderation is key. The bad stuff is unhealthy, and the good stuff is healthy to a point, after which it can turn unhealthy.
Maintaining a Healthy Financial Diet
So how do you make sure your “good” debt doesn’t reach artery-clogging levels?
Step one is to create a debt strategy. Robert Siuty, senior financial consultant at TD Ameritrade, suggested organizing your strategy as a set of rules and hierarchies, i.e., “do this, not that,” and “do this before that.” Here’s a sample:
- Know your limits. Don’t take on more obligations than you’re comfortable with. “Think about whether you or your spouse/partner would be able to pay for those obligations if you or a loved one gets sick or injured, changes employment, or passes away,” Siuty said.Make it part of the plan. Siuty suggested including debt management in your financial planning. And be sure to plan for the unexpected. Keep the good debt good. If you’re preparing for retirement, it’s a good time to check your balance sheet and start making some adjustments. You could argue that maintaining some good debt can help you build wealth for retirement. “It’s OK to use your credit cards, as long as you’re diligent about paying them off,” Siuty explained. “Using credit responsibly and establishing a track record of repayment can actually help raise your credit score.”Seek to minimize the effective cost of debt. “You might want to focus on paying off the debt with the highest interest rate first, then turn your attention to the debt that has a lower interest rate,” Siuty noted. Plus, some households are better served by keeping low-interest debt, receiving the tax benefits, and investing the excess cash flow to pursue a higher long-term rate of return. In a way, it’s like leveraging your wealth to try to build more wealth over time.Get help. You may also choose to seek help from a financial professional. “Having an advisor to help you pursue your goals could be a big help toward potentially accumulating assets,” Siuty mentioned, “mainly because an advisor can assist in keeping clients on track.” He recommended periodic reviews of your financial situation and to “make necessary changes along the way to help you pursue your goals.”
Working with a financial pro can help you map out the best long-term plan for your individual situation—from your first investment foray to retirement and beyond. For example, when you’re starting out, you might need help setting up an investment plan while also saving for the future. If you’re nearing retirement and have debt, consider reviewing your debt strategy with a financial advisor and developing a financial plan for paying off major items like new cars or home renovations once you’ve retired.
Sometimes debt can be a useful strategy, even in retirement. “You might spread payments out so you don’t need to take a large lump sum out of your investment or retirement accounts,” Siuty pointed out. “These are the types of decisions a financial professional can help with.”
Bottom Line on Debt: Recommended Daily Allowance?
Debt doesn’t have to be bad for your financial health, if it’s used wisely as part of an overall wealth-building plan. But it pays to understand the difference between the healthy kind and the unhealthy kind. And as with your diet, remember to exercise portion control—even with the so-called healthy stuff.
Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.