The topic of debt can trigger strong emotions. Some are adamant that debt should be avoided at all cost, while others scoff at the idea of paying upfront when low- or no-interest financing options are available. But many finance experts urge a more moderate approach.
“Debt does not have to be your enemy if handled responsibly,” says Michael Gerstman, the CEO of advisory firm Gerstman Financial Group LLC in Dallas. That means understanding why and when it makes sense to go into debt. To make smarter decisions about your money, brush up on the basics of debt — and learn how to avoid paying high interest rates — with this primer.
[See: 10 Easy Ways to Pay Off Debt]
What Is Debt?
Debt is incurred when someone owes another person or entity money. “(It’s) when you receive something of value, and you have to pay for it later down the road,” says Joseph Conroy, author of “Decades & Decisions: Financial Planning at Any Age,” and a financial advisor with advisory firm Synergy Financial Group in Towson, Maryland.
While people may borrow money to make investments, that is relatively rare nowadays, says Peter C. Earle, an economist for the American Institute for Economic Research. “Almost all consumer debt is to fund consumption, not investment,” he explains.
There is a concept in economics known as time preference, Earle says. It refers to the inclination of consumers to spend money on purchases now rather than save money to buy goods in the future. Low interest rates tend to spur high consumer spending, which in turn drives up debt. Unfortunately, this pattern of increasing household debt can also be a forbearer of a weakening economy, according to research published in November 2017 in The Quarterly Journal of Economics.
How Does Corporate Debt Differ From Consumer Debt?
Just as personal debt rises during times of low interest rates, so too does business debt. “The corporate debt market is about as large as it’s ever been,” Earle says.
When companies need an infusion of money, they can sell stocks or take on debt in the form of corporate bonds. The past decade of low interest rates has made the decision easy for many firms who have chosen to sell bonds.
[Read: What Is My Debt-to-Income Ratio?]
However, businesses tend to approach debt differently than consumers. Corporations consider if and how debt will benefit their bottom line, Conroy says. While people tend to go into debt for consumption — to buy things with diminishing value — businesses use debt as an investment to help spur growth.
Is There Good Debt?
When discussing debt, many people distinguish between good debt and bad debt. To understand the difference, Conroy suggests people consider debt in the same way a business would. “Good debt will put you in a better financial situation in the future. Bad debt doesn’t,” he says.
Conventional wisdom has long held that certain types of debt are generally good. For instance student loans are considered a good debt, because they provide an education that, in theory, leads to a high-paying job. Mortgages are also often labeled as a good debt, because real estate generally appreciates in value over time, and the interest expense may be deducted from taxes. Meanwhile, high-interest credit card debt is regularly categorized as bad debt and never beneficial.
However, the reality is that the difference between good debt and bad debt is more nuanced. “You buy a house and only put 5% down, and you have a problem potentially,” Gerstman says. If your income decreases or the housing market crashes, you could owe more on a home than it’s worth and not have the means to make payments. That could make this mortgage a bad debt. On the other hand, if the roof is leaking, paying for the repair with a credit card could be a good debt since it avoids a potentially greater expense in the future.
People should also think carefully before taking on student loans, Conroy says. Loans for an expensive out-of-state school may not be a good debt if you can spend a fraction of the cost at a local public university and get the same job in the end.
What Is Distressed Debt?
In some situations, people may look at debt as a way to make money. Distressed debt refers to bonds being sold by companies either in bankruptcy or near to it. Earle says these bonds may pay as much as 10% more than other corporate bonds.
Don’t be too quick to buy these though as they can be extremely risky. “Take it on with the expectation that you’re going to lose your money,” Gerstman says. While some investment experts specialize in distressed debt, Gerstman doesn’t recommend it for the average investor.
The decision to go into debt isn’t as clear-cut as it might seem. Before you agree to buy something before you can pay for it, consider how the purchase plays into your overall financial picture and whether it advances your long-term financial goals.
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