You might think that taking on any debt is a bad thing. But the truth is, there is such a thing as good debt vs. bad debt. And when it comes to good debt? Few types of debt are considered as beneficial as mortgage debt.
This is good news for future homebuyers who are worried about taking on mortgage debt. This is one kind of debt that meets all the definitions of what financial pros and mortgage lenders term “good debt.”
Good debt vs. bad debt
So what’s the difference between bad and good debt?
Timothy Wiedman, retired associate professor of management and human resources for Doane University in Crete, Nebraska, said that taking on manageable debt to fund the purchase of an asset that will likely appreciate in value each year can be thought of as good debt.
But taking on a loan to buy an asset that will likely lose value quickly? That's bad debt. So is using your credit card to purchase a flat-screen TV or furniture. This debt won't bring you anything that will rise in value.
"Borrowing to buy a quickly-depreciating asset such as a brand-new car, especially if one's current vehicle is roadworthy, is a good example of bad debt," Wiedman said.
Here's why: Say your new car costs $30,000. With a 10 percent down payment and 3.4 percent interest on a six-year loan, the total cost of that car, including financing, is almost $33,000. But after owning that car for four years, its value might fall to about $14,700, on average. And you'll still have two more years left to pay off the loan you took out for it.
But there's even worse debt than car loans, Wiedman said. Say you instead bought a new power boat that you only used on weekends three months of the year. Then you are taking on debt for an asset that not only depreciates but that you rarely use.
"That might be called 'really bad debt,'" Wiedman said.
Mortgages are examples of good debt
A mortgage can be considered the opposite of bad debt. You have to live somewhere, after all, and monthly apartment rent is just lost money.
When most people buy a home, they use it all the time. They also hope that its value will increase over time. There’s no guarantee of this, of course. But home values do typically rise if you look at housing prices in seven-year chunks. The odds are good, then, that buyers who plan on living in a home for at least this amount of time will see their homes’ values rise.
Mortgages come with low interest rates when compared to credit cards, another reason they are an example of good debt. It’s still possible, as of the writing of this story, to qualify for a 30-year, fixed-rate mortgage with a mortgage rate near 4 percent, a historically low figure for borrowing home-loan dollars.
You can also tap into the equity that you build in a home over time with home equity lines of credit or home equity loans. You can then use these loans to help fund home improvements, pay part of your children’s college educations or pay off higher-interest-rate credit-card debt.
Owning a home also comes with significant tax breaks. You can write off your property taxes and the amount of interest you pay on your mortgage each year.
“Good debt is debt that you can write off on your taxes,” said Michael Foguth, founder of Foguth Financial Group in Brighton, Michigan. “Debt that has an interest rate below 6 percent can also be considered good. Bad debt is debt that you cannot receive a tax deduction for. Also, debt that has an interest rate above 6 percent is considered bad.”
Examples of bad debt, according to Foguth? Credit-card debt, unsecured loans and high-interest-rate automobile loans.
Mortgage debt can bring financial gain
David Waldrop, president of Bridgeview Capital Advisors in El Dorado Hills, California, said that any debt that has the potential to bring financial gains should not be considered bad debt.
And taking out a mortgage to buy a home often does pay off for consumers, Waldrop said.
“Contrary to what some people say, a home is an asset,” Waldrop said. “While it may be scary to have a mortgage debt of $400,000, you now have an asset worth close to the same amount. Owning a home has the potential to grow wealth over the long-term. While the interest you pay on a mortgage is significant, historical returns on real estate over the long-term can still put you way ahead.”