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Good Debt vs. Bad Debt

Since May of 2013 the Government has raised its benchmark interest rate on the 10 year Treasury bond over 30% in under six weeks giving banks and lenders the long awaited green light to raise rates on many varieties of loans we use. We carry many forms of debt on our household balance sheet and it is difficult to escape the machinations of the changing interest rate as
the effects seep through our markets and into our homes.

The movements of interest rates are felt every day as we go about our lives. The interest rate determines the "cost of money". The gravity of the interest rate on our lives is analogous to our Moon's influence on the ocean's tides, subtle movements with far reaching implications.

One of the first things that I noticed with then increasing rate was the rates on some of the most commonly held loans started to rise such as the 30 year fixed rate mortgage, student loans, and auto loans. Now may be a good time to talk about good versus bad debt. We leverage the ability to borrow money to make our lives more convenient but it can have the opposite effect if misused. Now that interest rates are rising that means payments will increase on loans as well, and it will cost more to acquire the same goods.

When we use credit to buy things in many cases like a home or a major purchase such as an automobile there aren't many tractable options to pay other than a multiyear loan. This type of debt allows us to enjoy ownership of an item or asset without the burden of a large upfront payment. Loans that are backed by an asset that appreciates or holds its value are beneficial to own as it allow you to use the asset, participate in any appreciation in value, and sell it when you are done. The home is the most common example of this, which may be considered "good debt:" you have an enjoyable use from it.

Other loans that would otherwise be beneficial can end up being a detriment. One scenario is having many small loans obtained for things that could otherwise be purchased outright with cash. This practice can end up eroding even the strongest balance sheets over time. In addition to the interest on the loan there are usually other costs associated with borrowing money such as origination fees or a prepayment penalty. In almost all cases the math will quickly reveal that the price of anything bought using credit will be much more than the original purchase price. This type of debt is usually associated with assets and items that don't hold value such as electronics and discretionary purchases, which often are unusable long before they are paid off. This can be considered "bad debt."

While it is our practice to have all of our clients as debt free as possible, it is almost impossible to escape the long arm of lending but employing a few simple strategies and rules of thumb can help loosen the grip over time. Spend wisely, my friends!

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