BrightPlan Team
Have you ever eaten too many donut holes? The first two or three send you to heaven. But as you eat seven, eight, nine … not so heavenly. You’ve had too much of a good thing.
Debt is a lot like donuts in that regard. Borrowing can be a great tool that allows you to accelerate toward your goals. But too much debt can leave you with a financial stomachache. Like most things, it’s best in moderation.
So how do you know what debt to avoid and what debt to consider?
Defining Good and Bad Debt
At the risk of over-simplifying, let’s split it into two categories: Good Debt and Bad Debt.
Good Debt: /ɡo͝od det/ noun; Borrowing money at a low interest rate to increase your earning potential or buy assets you expect to grow in value over time.
Bad Debt: /bād det/ noun; Borrowing money at a high interest rate to purchase items that go down in value.
Examples of Good and Bad Debt
Mortgages, student loans, and business loans can be good debt. Think about getting a college degree. By taking on student loans for a few years you can increase your earning power over a lifetime.
Mortgages can also be good debt. These loans create “forced savings” as you whittle away at the principal with your payments, your home price has potential to appreciate, and there are tax benefits homeowners enjoy that renters do not.
The prime examples of bad debt are consumer debts such as payday loans, personal loans, and enemy #1: credit card debt. Unlike good debts which can improve your financial position, consumer debt racks up interest while the items you bought lose value.
Don’t get me wrong, credit cards are a great way to make purchase. But the high interest charged for carrying a balance on a credit card makes paying them off each month a necessity.
Financing a fancy lifestyle with bad debt may be normal for many people, but that doesn’t make it smart. Never forget, these debt products are not sold to enrich you. They’re designed to make it easier to buy on impulse, to tie up your income, and to drive revenue for the companies that constantly market them in your mailbox and on TV.
Too Much of a Good Thing…
One more note about “good” debt. Remember the donut holes, everything in moderation.
Taking on good debt is exciting. You get to invest in something you care tremendously about. You imagine the benefits you’ll reap for years down the road. But too much good debt can be a bad thing.
Graduating with student debt is manageable when there are jobs to take and dollars to earn. However, taking on substantial student debt to earn a degree that may not lead to a higher paying job can cause a financial stomach ache.
When you find your dream home, you are through the moon. That could be short lived though if you can no longer afford to go to your favorite yoga class or eat at the best food truck in the city.
Taking on too much mortgage debt can lead to becoming house-poor. You have a beautiful home with financial value but no margin with your money to enjoy the rest of life.
How Much is Too Much?
It’d be great if someone warned you that the next donut hole would be the one that causes a problem. Luckily, the debt-to income ratio is a good metric to determine that fine line of how much debt is “too much.”
You can calculate your debt-to-income ratio by taking the sum of all your monthly debt payments and dividing it by your gross monthly income (before you pay taxes, contribute to savings, etc).
Where do you fall? In general, a debt-to-income ratio below 20% is great, and anything above 40% is a sign of financial stress. If yours is above 40%, it may be time to find ways to cut back your spending.
All debt has one very key thing in common: it costs to borrow money. So before you take on any debt, think about why you’re incurring that cost and how your choice will impact your goals.