Debt. It’s not all “ugh.” Many of us will take on debt at some point in our lives, which enables us to go to school or buy a home when we otherwise couldn’t.
So, some debt can be “good,” but much of it is “bad.” And too much debt…when you can’t see your way to repay it…is always bad. The old rule of thumb for “too much?” When interest payments exceed 20% of your take-home pay — that’s higher than we would advise.
How can you tell the difference between “good debt” and “bad debt?”
One form of potentially good debt can be student loan debt. A great education can lead to a more interesting job, which can increase your earnings. Student loan rates can be as low as 3.4%, or can range up to 7%. But you may be able to deduct student loan interest payments of up to $2,500, depending on your income level, which reduces the annual cost of the loan.
Another form of “good debt” can be a mortgage to buy a home. It’s good because, well, you have a home. That can also be a form of investment, over time, if the value of the home goes up. Interest rates on mortgages can be low (like 5%) and the interest payments can be tax-deductible — which, again, can make this kind of debt less expensive.
What should you do if you have the money to pay off “good” debt?
Well, the question becomes, “What else could you do with that money?”
At Ellevest, we expect a diversified investment portfolio to return anywhere from 5.3% to 9% a year — not as much in some years, more in other years — but this is what we expect that it will average*. So, over time, it can make sense to keep that debt outstanding and invest in the markets, to earn the difference between the two.
But we would note that this can be a personal choice. Some people prefer to get debt — even low-cost debt — paid off and done with.
Ok, so that’s the “good debt.” One type of debt that is never good? Credit card debt. Never, ever, ever. Interest rates on credit cards today range from 13.7% to 23.8%.. It’s absolutely nuts. And there’s no tax break on that interest. So, buy something for $1000 on a credit card in the middle of that range of interest, and a year later it will cost you more than $1,270 to pay it off. It’s like you bought it on “un-sale.”
The best rule for using credit cards: If you need to rack up credit card debt to buy something, don’t buy it. Seriously. Just don’t buy it. If you have credit card debt, pay it off as soon as you possibly can.
“Wait,” you may be saying. “What about my emergency fund? That’s at least three months of salary that I’ve been told to stash away in cash for emergencies. Should I use my Emergency Fund to pay down my credit card?”
The answer is yes: take the money out of the emergency fund and pay down the credit card. Right now. That’s because cash is fungible; if you really need that emergency money, you can spend on your credit cards when you have to. But in the meantime that emergency cash is earning you next to nothing and your credit card is costing you an arm and an ear.
So, in review…
1) Shoot for (much) less than 20% of take-home salary going to interest payments. Adjust your other spending and lifestyle, if need be, to get there.
2) Pay off credit cards in full immediately…or as soon as you possibly can.
3) Consider keeping debt that costs you less than 5% a year outstanding and investing your money in a diversified portfolio.
4) For everything in between, it can be a personal choice. (And, frankly, we lean towards paying off as you are able to.)
*This range of pre-tax returns is based upon proprietary capital market assumptions from Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., and assumes a diversified portfolio of stocks and bonds, ranging from 25% stocks and 75% bonds to 80% stocks and 20% bonds. Past performance is not an indication of future results.
© 2018 Ellevest, Inc. All Rights Reserved.
The projections of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness. The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person. Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time. Forecasts or projections of investment outcomes in investment plans are estimates only, based upon numerous assumptions about future capital markets returns and economic factors. As estimates, they are imprecise and hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The practice of investing a fixed dollar amount on a regular basis does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.