People feel strongly about debt. Many of us have an almost innate sense of fear or wariness about borrowing money, and we know people who got too deep in debt and suffered as a result. Yet borrowing is also an almost universal fixture in American life today: student loans, credit cards, car loans, mortgages, etc. As uncomfortable as it makes some of us, we’ve nearly all borrowed money at one time or another.

We’re not philosophically opposed to borrowing.  When clients ask us whether and when they should pay off their loans, we try to help them answer the question within the context of their own value system and specify the economic cost for them. Below are some questions we use to help clients answer the debt question.

Would paying off the debt bring you peace of mind?

We have never met anyone who regretted paying off a loan. Debt is an obligation and encumbers our freedom, and sometimes the best life decisions are more important than a purely financial analysis.

What type of asset is the debt tied to?

No one wakes up in the morning to find out that they’re suddenly in debt. Debt is usually the result of a purchase decision. It may be helpful to differentiate between assets by comparing their future values:

  1. Appreciating assets rise in value over time. Houses, certain collectibles, and investments are examples of assets which hold the potential to grow in value.
  2. Depreciating assets decline in value. Vehicles – unless they are truly collectible – are probably the most common example. Capital equipment used in a business is another type of depreciating asset.
  3. Depleting assets lose their entire financial value immediately. Dinners at restaurants and vacations are “assets” whose values deplete as soon as the experience is over.

Appreciating assets provide the owner/borrower flexibility to sell the asset to pay back the debt. Assets that lose value may leave the borrower with debt that cannot be repaid with the proceeds from selling the underlying asset, if it can be sold at all.

Is the debt tax-deductible?

Home mortgage interest is deductible up to $750,000 of borrowing in 2018, but changes to the tax law in 2017 eliminated the deduction for home equity loan interest. The deduction for mortgage insurance premiums is also gone.

Is the interest rate variable and / or high?

In a rising interest rate environment, variable interest rate debt (a.k.a. “floating rate”) takes a progressively larger bite out of your budget. Whether an interest rate is high is relative, but unpaid credit card balances, and personal loans with rates more than two times prime (5% at this writing) are high.

Good Debt vs. Bad Debt

Using those questions to frame the decision, we offer two simple examples of clearly “good” and clearly “bad” debt.

Good debt: a 30-year fixed-rate 4.5% mortgage, with a loan to value rate of 75% or less, and carrying a monthly payment less than 25% of your net income is a responsible use of borrowing. First, the asset (your home) stands to appreciate over time – even if only by the rate of inflation. Secondly, the interest is at least partially tax deductible, which reduces the effective loan rate to 2.7% for high-income households. The interest rate is also fixed for 30 years. Finally, many people aspire to home ownership. Owning a home is also a primary means of building wealth.

Bad debt: putting an expensive vacation on a credit card, then making only the minimum payment. Credit card rates are almost always very high; the interest is not deductible; and the financial value of the vacation is gone immediately.

Summary

The financial question of debt is a classic two-edged sword. Entrepreneurs, home buyers, and municipalities use good debt to build and improve lives. Many people have also hurt themselves using bad debt for discretionary purchases. Before sorting out the financial question of debt, ask yourself whether being free of debt would make your life more enjoyable.