You've probably been conditioned to think that debt is a bad word and couldn't possibly have anything good associated with it. However debt can be a useful financial tool and when principals of proper debt management are applied it can actually be very beneficial. But it is important to separate good debt from bad debt. Good debt generally falls under the category of financing investments that have potential for appreciation. Examples include, mortgage financing, education financing (investing in both your mind and future earnings ability) and also business venture financing when a calculated risk is measured and has been determined to be acceptable. Almost all other forms of debt are bad.
The Benefits of Debt:
The ability to leverage your purchasing power. For example when you purchase a home with little or no money down and finance the balance, your return at the time of sale will likely be far greater than 100% of your initial investment. When debt is used in this productive capacity, you could be amplifying the return on your investment.
Convenience and liquidity. If you have immediate short term cash needs and have most of your money fully invested, it could make sense to avoid cashing in any investment accounts, potentially paying taxes and penalties in doing so, and simply utilizing a line of credit. This also assumes that the cash you have fully invested will return a higher rate to you than the rate you would be paying out on the line of credit.
Exercising your credit muscle can keep you a credit worthy customer. It seems trite but true that it's easier to get credit once you have already had it and established your ability as a sensible credit managing consumer.
The Drawbacks of Debt:
Debt comes with a real price, interest. Even in situations where the interest is tax deductible it is still an expense. There are many misconceptions surrounding the tax benefits of real estate mortgage interest. Mortgage interest is a possible deduction on your tax return but many homeowners overemphasize the impact of this tax break and misconstrue how it really works. The tax break received on mortgage interest is limited by one's federal tax bracket. Suppose you are tax payer in the 25% middle income bracket, which means that for every dollar you pay in mortgage interest, you would save 25 cents on your federal income taxes. If you are in a higher or lower tax bracket, that would mean saving 35 or 15 cents per mortgage interest dollar spent. Many new homeowners will use the argument that they needed to purchase a home because they need a tax break. However this argument is not a logical one because in reality you are paying out a dollar to receive 25, 35 or 15 cents in exchange. To utilize the tax breaks of home ownership, you must have enough deductions to justify itemizing them. Yet almost 70% of all taxpayers take the standard deduction and do not itemize.
Just as leveraging can enhance your purchasing power and return on investment, it can also accelerate your loses. Take for instance the practice of purchasing securities through margin buying. Margin buying is a way of acquiring securities using some of your own money along with funds from a loan provided by the securities broker. The underlying security serves as collateral for the loan. In the event the security actually drops in value, the borrower on margin could then be put in the somewhat shocking position of having to repay a sum well in excess of the initial cash that was put down to acquire the asset, thus losing 100%+ of their initial investment.
What if your financial assumptions are off the mark? At the time you choose to borrow, you assume that your income will either remain the same or increase and that you will be able to service the debt payments without any problem. However if you hit a bump in the road, lose a job or are required to transition into a new career, you may find it difficult to make these adjustments if you are over burdened by debt.
Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.