Good vs Bad Debt: A CFP's Perspective on this Old Wisdom
The idea of good and bad debt is something many households are familiar with. We often use terms like ‘good’ or ‘bad’ to describe loans such as mortgages, auto loans, personal loans, or credit cards. We look forward to paying down the bad, but we're not sure if we're doing it right or in the most efficient manner. This blog post seeks to clarify all of this and give you a framework to put all of your accounts into perspective.
What exactly makes a loan good or bad? To answer this question, we must look at several factors including the interest rate framework, fixed versus variable loans, liquidity premium on top of the risk-free rate, and how to identify which debt should be paid off and which can remain at minimum payback. Don't worry - this will be in simple English, with some translation on my part.
Fixed Versus Variable Loans
One way to assess the quality of a loan is by looking at whether it is a fixed-rate loan or a variable-rate loan. A fixed-rate loan means the interest rate is set for the life of the loan and will not change, regardless of market conditions. A variable-rate loan, on the other hand, will fluctuate with interest rates in the economy at large.
Typically, variable-rate loans come with lower APRs (interest rates) at the beginning while letting the later interest rates change. A lower APR is great, right? Well, not if we have rising interest rates like we have in the past few months. These loans are riskier than a fixed-rate loan precisely because of this possible situation. Today, everyone with variable rate loans is facing interest 2-3x what they originally signed up for. The worst part - it was all in the contract to begin with. When you're faced with a choice between a fixed rate and a variable rate (with a slightly lower APR), if you don't like the fixed rate, you probably shouldn't take either of the loans.
Relation to the Risk-Free Rate
Consider the risk-free rate your benchmark to measure your debt against to determine if it's "good" or "bad". Wait - what's a risk-free rate? The risk-free rate is the rate you'd earn if you invested in a bond with absolutely no risk of default. This rate is usually close to the current interest rates set by the Federal Reserve. To look up the risk-free rate, simply head over to their website and search for "federal funds rate". Here's the direct link: https://www.newyorkfed.org/markets/reference-rates/effr
As I'm writing this the risk-free rate is 5.33%. As a general rule of thumb, all loans with an APR below this would be labeled "good debt" while loans above this would be "bad debt". Some examples of good debt might be a mortgage at 3%, or an auto loan at 4.5%. Bad debt would include credit cards, some newer auto loans at 6-7%, and pretty much every signature loan.
We all know, pay your credit card statement every month. This is because a 20-24% loan is literally the worst thing in this framework. It's so far above the risk-free rate that you should be doing everything in your power to pay them off FAST.
How To Identify Which Debt To Pay Off & Minimums On
When looking at all of your debts, start by identifying which are in the "good debt" category and which are in the "bad debt" category.
Good debts should be set on autopilot, with minimum payments being made every month. But don't get carried away with the amount of "good" debt you take on. Taken to the extreme, a mortgage at 3% can still overwhelm a family if the monthly payments are too large, or if they fail to have an adequate safety net in the event of a layoff or medical event.
As for bad debt, these should be ranked by their APR. The highest APR should be put at the front of the line, with every additional dollar going towards them. Remember to make minimum payments on all accounts! As the highest APR account is paid, you move to the next highest APR until you hit the risk-free rate (which is the transition to "good" debt).
Credit cards and intro periods
A lot of us get tricked by the 0% interest rate for the first year or two. While this is a great opportunity to save money, don't forget that after the intro period ends you'll be paying much higher rates. If possible, try to pay off the balance before then. One trick I like to use is to deposit the total amount of the card's balance into a high-yield savings account. When I am close to the end of a promo period, I pay the entire balance in one month! Remember to make minimum payments every month and to keep your total credit usage below 10%. If you don't know about the credit utilization ratio, it's a big factor in your credit score!
Interest Rates Change Slowly (most of the time)
Interest rates in general change slowly over months and even years. So it should not be viewed as something that needs constant attention, but rather as part of your regular financial maintenance routine every few months or so. Today the fed funds (risk-free) rate is 5.33%, but last year at this time it was 2.33%. There were very few "good" debts back then. When we look at where our money should go in the future, it's important to evaluate this important metric.
Using High-Yield Savings Accounts
We have discussed how to handle accounts above the risk-free rate, but what do we do once we have paid those off? The simple answer is to earn a higher yield on your money than the cost of the "good" debt. This is where high-yield savings accounts come into play. Many banks are offering rates close to 4.5% on your savings -- which can easily exceed the cost of a 3% mortgage. A typical rule of thumb is to have 3-6 months of living expenses in this account. Once you reach that, you might start looking at investing your dollars in stocks/bonds!
In conclusion, knowing the current risk-free rate and understanding the difference between "good" and "bad" debt can save you a lot of money when it comes to debt. Knowing which loan type is best for your situation is key -- don't take on too much "good" debt, but also be mindful of those risky variable loans. And finally, look into high-yield savings accounts for after you pay off your bad debt!