There is probably no good debt, although some people may debate and say that a home mortgage is a good debt because it allows you to stop paying money to rent and helps build your credit. Still, even with a home mortgage, it is usually better to pay the debt off than it is to hold onto a home mortgage. Doing so allows you to stop paying interest on the loan, which means more money in your pocket for saving and investing. It also reduces your risk since all you need to then do to keep your home is keep paying the property taxes. If you lose your job, all you need to do is pull together maybe a couple of thousand dollars per year and you won’t need to worry about keeping a roof over your head.
Still, mortgage debt isn’t what I would call poisonous debt – debt that is very difficult to control and that will tend to grow with time unless you are very diligent. That kind of debt has the following characteristics:
1. It has a high interest rate. Take 72 and divide by the interest rate. That simple calculation will tell you how many years it would take a debt to double if left alone. If you have a 4% home loan, it will take a little less than 20 years to double, meaning that you will pay about twice the loan amount for your home by the time you pay off a 30-year mortgage. For a 20% interest credit card, it will double about every three and a half years. Take three years to pay off something you buy on a credit card, and you’ll pay double. How’s that $14 latte taste?
High interest makes a debt poisonous because you end up paying a lot of interest each month, so the total amount of the debt rarely goes down. For example, if you owe $10,000 on a credit card at 20% interest, the first $167 you pay just goes towards paying down the interest. Pay $250 and you’ll only knock the balance down by about $83. If you make $30 per hour after taxes, that means you’re working the better part of a day per month just to pay the interest on your credit cards!
2. It is for something that goes down in value. If you take out a loan to buy something that goes up in value like a home, the increase in the value over time will reduce the amount you actually pay for the item. This, in addition to the effects of inflation, help you get rid of the debt. Plus, when you’re done you have something for all of the money you’ve paid. Buy something like a car on credit, however, and you may very well owe more on the car than it’s worth during most of the time that you have the loan. By the time you finally pay off the loan and own the car, it may be time to buy another one if you take out a 6-year loan. At the end of the car loan, all of the money you paid is just gone.
3. It has a variable interest rate. You must remember that the lender is in control when you have a loan. The only thing worse than owing money is owing money where the lender can change the terms on you. You don’t want a loan like a variable rate home loan or a credit card where the payments may rise to the point where you cannot afford to make them. You also don’t want your lender to be able to raise rates until you’re stuck in debt forever.
So, based on these criteria, what are the poison loans that you should pay off first, or never get into in the first place? Here are different types of debt listed from worst to best:
- Payday loans: Both have high interest rates and are generally for something that goes down in value.
- Credit cards: Credit cards have high interest rates and often variable rates. Plus, be late for a payment and you could see your interest rate go up to 35% or more.
- Margin Interest: This is interest charged by a brokerage firm for buying securities beyond your means. The danger here is that you may be forced to lock in a loss should your investments go against you. Plus, the interest rates aren’t all that good.
- Car Loans: If you need a loan to buy a car, it means that you are buying more car than you can afford. Instead, save for a few months and buy a $3,000 car for cash from a private owner. Drive that for a year or two, saving payments all of the time, then trade up for a $8,000 car. Then, either continue to trade up or just be happy with $8,000 cars (they aren’t bad at all).
- Student Loans: If you can get through college without student loans, do so. The interest rates tend to be very low because they’re taxpayer subsidized, but it is better to start life with no debt so that you can get into a house and stop paying rent. If you must take on student debt, take on as little as possible by graduating fast and then keep living like a student for a few years after college until you pay that debt off.
- Home Equity Loans: Again, if you’re taking out a loan on your home, it means you’re buying things you can’t afford. It is better to save up and pay cash if at all possible. Plus, HELOCs can carry interest rates of 5-8%, so these will consume a good portion of your income.
- Home Loan: A home loan can be a good debt because it allows you to stop paying rent and leverage the value of an expensive asset, your home, to build wealth. If you buy a $250,000 home, you’ll get to keep the appreciation on that home, which might be a real help when you’re ready to retire if you’re willing to downsize and/or move to a cheaper area. Keep these loans at 15 years or less and make sure the rate is fixed. Plus, keeping your mortgage payment below 25% of your take-home pay will make it a lot easier to make the payments.
Thanks to reader, Jessica, who suggested the topic for this post. Keep them coming!
Your investing questions are wanted. Please send firstname.lastname@example.org or leave in a comment.
Follow on Twitter to get news about new articles. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.