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by Matt Bushard
Debt has become a bit of a 4-letter word when it comes to financial planning, but not all debt is created equal. Some types of debt can actually be considered healthy.
Healthy debt is any kind of investment that will grow in value or provide long-term income. A mortgage, whether for a home or a business, could be considered healthy debt. Along those same lines, student loans can be considered healthy debt if you use the degree to find a job that produces a higher income.
Interest rates are usually lower and terms are typically more favorable for loans that might be considered healthy debt. They can sometimes offer tax advantages, too.
A home equity loan used to improve your home or business can be considered healthy – especially if the rates are favorable – because it would add value to your property.
But keep in mind, even with “healthy” debt, it’s important to make good choices. If you make yourself house-poor buying a home outside of your means, or if you take out student loans but don’t end up finishing the degree, then you could be taking on debt that doesn’t provide value.
Unhealthy debt is typically used for things you want, not necessarily what you need. And it often comes with a higher interest rate.
Credit cards, payday loans and cash advance loans all can be types of unhealthy debt if you let them accumulate. That can be harmful, luring you into a debt trap you have a hard time escaping.
Some types of debt fall into a gray area – not necessarily healthy or unhealthy. This includes debt such as vehicle loans. A vehicle depreciates in value, but it might be necessary to get to work or do your job. Making smart decisions about the vehicle you buy, how your debt is structured and your ability to pay it off can determine whether this type of debt would be considered healthy or unhealthy. Car loans with especially high interest rates (around 6 to 9 percent) would be unhealthy debt.
A 401(k) loan can be good, but if you don’t pay it off within 5 years, it becomes taxable income. And if you’re using the loan for something you want instead of something you need, you would be borrowing on your retirement funds to get yourself into unhealthy debt.
Debt consolidation can be healthy if you’re able to find more favorable terms – such as through a home equity loan. But you also have to change the habits that lead to the debt. Sometimes people think of debt consolidation as “clearing the slate” and they end up taking on more debt.
Avoid using debt to pay off debt if possible, and instead try to work more and cut back your spending.
When paying down debt, focus on unhealthy debt first. Once you’ve knocked that out, put more money toward debt that falls into the gray area before tackling healthy debt.
Shoot for a debt-to-income ratio of 36 percent or less. That’s total debt (both healthy and unhealthy) divided by your monthly income before taxes and other deductions.
Wealth management is an important part of working toward your financial goals. Contact me for help putting together a comprehensive financial plan.
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