USING DEBT TO BUILD WEALTH

Defining Good Debt and Bad Debt

Determining if a particular debt is favorable or unfavorable relies on various aspects. These include the interest rate, the loan repayment duration, and the purpose for which you're borrowing the money. Equally crucial is your individual capacity to handle debt.

In essence, beneficial debt involves borrowing to create lasting prosperity, while harmful debt can damage your credit and drain your finances. The contrast between them boils down to two key aspects: risk and cost.

“I would equate bad debt with taking on too much risk without the ability to repay it,” says David Mook, senior vice president and chief private banking officer at U.S. Bank Private Wealth Management. “Bad debt is either too risky or too costly.”

Car loans used to purchase private cars are common example of bad debt because they’re used to buy an asset that depreciates. In general, Borrowing to support ongoing living expenses is not a good use of debt.

Using Good Debt To Achieve Your Objectives

Student loans are probably the most common example of good debt, given the correlation between a college degree and higher earnings throughout your career. But that’s just the start. “Good debt can help borrowers accomplish an objective or help them avoid a bad outcome,” says Mook.

When it comes to accomplishing your objectives, consider another common example of good debt: taking out a mortgage on a new house. For most people, it’s not possible to pay for a house outright. However, even if you were able to pay for it in one large payment, there are benefits to taking on debt for a home. Paying down a mortgage results in equity in a home as well as potential tax advantages. Plus, if you know you’ll be able to make your monthly payment, there is the additional benefit of improving your credit score by making the payments consistently.

Depending on your circumstances and risk tolerance, leveraged investing can be another good debt strategy. Say you’re investing $100 with an expected 10% rate of return. If you invested your own money, you would earn $10. But if you were to invest half your money and borrow for the other half, you could earn more, if the interest on the loan is less than 10%. In this example, says Mook, “you leveraged your return.”

Another potentially effective debt strategy involves using a loan to diversify your investment portfolio, especially for certain affluent individuals who hold a concentrated stock position in a single company. They can borrow against that concentrated position to buy stocks in other companies, making for a more balanced long-term investment strategy. An added benefit of borrowing against a concentrated stock position to diversify your portfolio is that you may defer paying the capital gains tax you would incur if you sold the concentrated stock.

Good debt may help you avoid bad outcomes

Mook recounts how a client, who was anticipating a cash payment in June, faced a substantial tax obligation on April 15. While the client had the option to liquidate assets from their portfolio to cover the tax bill, this would have necessitated portfolio reconstruction, incurring transaction expenses, and potentially additional taxes. Consequently, the client chose an alternative approach: taking out a loan to settle the tax debt and subsequently repaying it in June. Mook elucidates, "The avoidance of portfolio disruption serves as an illustration of utilizing debt effectively."

Assessing your debt tolerance

Your comfort in dealing with a certain level of debt is contingent upon your risk tolerance," Mook explains. "It's crucial to comprehend the potential drawbacks of assuming debt so that you can gauge your comfort with the associated risks."

For instance, if you decide to borrow money to diversify your investment portfolio, are you prepared to weather a period of market volatility? Additionally, consider your time horizon: Do you have a firm commitment to paying off investment-related debt within two years, or would you be content if it took longer? Asking questions like these can aid in evaluating whether you are at ease with the idea of incorporating debt into your investment strategy.

To be continued.....