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Consumer Debt is Up – But is it All Bad? The Theory of “Good” Debt

Nov. 3, 2012
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“Debt” is a dirty word. It makes people cringe, but it doesn’t have to—there is such a thing as good debt. Typically, when people talk about this brand of debt, they list three in particular: student loans, auto loans, and mortgages. More generally, you can understand so-called “good” debt as a loan that is either a necessity—your car—or one that promises a bigger and brighter future—with higher education. That’s one reason why some people are still optimistic about the American consumer debt profile: student loans may be up, but at least credit card debt is down.

The thing is, people define that “better future” differently. For some, it’s simply financial solvency, and for others it’s the guarantee of a Beamer with a subwoofer in the back. For others still, some traditionally “good” are no longer so, thanks to the recession. As you’ll see below, however, the decline of “good” debt is a bit overhyped. Simply put, good debt remains good debt until you’re unable to pay it off.

Your education

An education is an investment, and one you expect will yield dividends in the future. Even entry-level jobs typically require a 4-year degree, and, as you move up the ladder, that list of requirements can grow. And there’s reason: a higher salary demands higher education.

To get there, many students have to take out a student loan. And for many of them, that student loan is “good” debt, if begrudgingly so, because their degree is an investment.

There is, of course, a caveat to my endorsement of student loans. Especially since 2007, some critics have bashed appraisals like mine as, well, smacking of privilege. And to some extent, they’re absolutely correct. For some, student loans are a boon, and, for others, a burden, one they’ll be shrugging off for years. Some simply can’t escape loans, at which point this good debt becomes absolutely terrible debt: if you default on your student loans, they don’t go away, even if you declare bankruptcy. You may also end up ineligible for future loans.

You do not want that future. But if you’re financially less fortunate, it’s a future you’ll have to consider prudently.  If you know you’ll have to finance quite a bit of your higher education with student loans, then you should also have a very clear budget and even a career path.

Jane E. Babel, who counsels high school students about post-secondary education, lays out clear steps for her clients. “If they aren’t sure about their future career plans, I tell them to start with this figure: $45,000. That is the median salary of a college graduate in this country, according to the U.S. Department of Education,” she said. Once a student arrives at a projected salary, he or she should take out in loans no more than their anticipated annual income.

There are quite a few ways to cut corners, too. Attend community college for a couple years and then transfer to a four-year university, apply to public, in-state schools, and, if possible, live at home.

Whatever the plan, the college-bound need to ensure that their student loans don’t slide from good debt—a reasonable income and good credit—to bad debt—a low-paying career and years of loans.

Your Car

In her song “Handshakes,” Emily Haines, of the band Metric, sings over wailing guitars: “Buy this car to drive to work / Drive to work to pay for this car / Buy this car to drive to work / Drive to work to pay for this car.” It goes on like that.

Haines expresses with style what we all know about your auto loan: it’s a loan you just can’t do without—unless you have the cash to pay for your car up front, or, for the select few, you live just down the block from the office. Your auto loan is “good” debt simply because you need wheels.

The degree of its “goodness” depends on the borrower’s tastes. If you’re a car enthusiast, your car’s sheen, make, model, and year are of utmost importance. Because it finances the hobby you love, your loan may even be a great debt.

But for others, this debt’s “goodness” is a much more precarious attribute. Unlike your home, your car almost surely will not appreciate in value. While your home, with fix-ups, renovations, and additions, may indeed increase in value, it’s extremely rare that your car will do the same. Its value begins depreciating as soon as you get behind the wheel.

If your auto is simply a means to get to and from work and nothing more, then you should take a look at used cars. Otherwise that “good” debt could become awfully burdensome.

Your home

Your mortgage is a unique investment, unlike stocks and bonds.

“Real estate is one of the actual investments that you can take on that is tangible,” said Michael Shenfeld, a real estate consultant in Chicago. “It’s a place where you can live.”

Your mortgage is versatile, too: You can also use it as capital—if you borrow against it with a home equity loan—or as income—if you sell once you’re ready to leave.

For the aforementioned reasons, economists have traditionally called mortgages “good” debt. That term, however, has been especially contentious since 2007, when the lending bubble burst and, in many areas, home prices plummeted.

The big picture, however, is much more nuanced. “Negative publicity sells and people have been down about the market ever since it started to slip right around 2007 or 2008,” Shenfeld said. Home prices are on the rise, though, and Shenfeld expects they will continue to do so.

Moreover, the bubble that burst wasn’t necessarily a national one: it was a collection of smaller bubbles, specific to each given community. For example, on the north side of Chicago, where Shenfeld works, the real estate market wasn’t hit quite as hard as some its Midwestern neighbors, including Detroit.

“We never really had the bubble that other areas had,” he said. Lending practices were tighter than, say, those in California real estate, a market that Shenfeld’s studied in depth. Out West, some sellers expected their homes to appreciate as much as 100% or even 300% percent, Shenfeld said. In inflated markets like that one, sellers and lenders have suffered a much more extreme correction: the bubble grew quite large, and, once it burst, it got quite a few wet.

Chicago was much luckier. “Our standard appreciation was 5.9%, so it didn’t need much correcting,” Shenfeld said. The reason: “Conservative people, conservative investors, conservative buyers.”

Your mortgage’s “goodness,” then, really is a matter of where you live and, of course, your own personal finances. In fact, if you can afford to move, and you’d like a larger home, you can often find one at much lower price and with much lower interest rates.  Even if you do sell low, you can buy even lower if you play your cards right.