You might hear it said that buying a home with the help of a loan is always a good decision because a home loan is “good debt.” In a culture that regularly warns youngsters and financial novices about the dangers of debt and compound interest, this sounds like an oxymoron.
Debt is often a financial and practical hindrance; it prevents people from accumulating wealth and sometimes leads them down the road to bankruptcy. Can there really be such a thing as good debt? And is buying a home an example of it?
What Is Good Debt?
Let’s define what “good” debt actually is. Good debt is any debt that provides you with economic or practical opportunities that outweigh the costs of the commitment.
In other words, good debt helps you accomplish something desirable without costing you more in the meantime. One of the most commonly cited examples of good debt is a student loan.
In this case, you take out a loan for money you can use to obtain a higher education. Once you have a college degree, you’ll have more economic opportunities for the rest of your life, and ultimately earn hundreds of thousands to millions of dollars more than you would have with only a high school diploma.
Because student loans also carry relatively low interest rates, the transaction makes sense. Good debt can also be useful for other forms of wealth building and income generation, if you know what you’re doing.
Examples of Bad Debt
It’s perhaps easier to understand the form and function of good debt when you know what bad debt looks like. Bad debt features excessive costs, without furnishing many financial or practical benefits in return.
For example, let’s say you max out a credit card buying $10,000 worth of clothes and video games. These assets won’t generate income for you, nor will they appreciate in value. If you sold them all, you might get only $3,000 to $5,000 back for them.
At the same time, your credit card’s high interest rate will steadily expand the amount you owe.
How a Home Loan Can Serve as Good Debt
Can a home loan serve as good debt? The answer is clearly yes, and in many different ways. Here are some:
- Building equity (instead of renting). For starters, getting a home loan allows you to build equity, rather than spend all your money on rent. If your rent payments used to be $1,500 per month and you’re now paying $1,700 on a mortgage, you’ll be ahead of the game: Your payment will be used to pay down your principal and interest, which increases your ownership stake in the property. If you can’t buy a property all in cash, a loan is the only realistic path to home ownership.
- Financial leverage and property appreciation. Home loans also allow you to take advantage of financial leverage. Through this, you can fund the purchase of a new asset using borrowed funds rather than established equity. This means you boost your total investments without requiring extra cash. Assuming your investments pay off, this also expands the amount of money you can make with each transaction. Buying a property with the help of financial leverage allows you to snowball your wealth much faster than you could have otherwise.
- A hedge against inflation. Debt can also grant you a financial advantage if you suspect high rates of inflation in the future. During periods of economic inflation, the value of money falls. If you have savings that aren’t earning much interest, the actual spending power (and value) of those savings will decline as inflation takes hold. But in the case of debt, the effect is the opposite: Because the value of your debt will lessen during rising inflation, you’ll end up owing less over time … not in terms of the dollar amount, but in terms of spending power and value.
- Opportunities to rent. Purchasing a property with a loan could also give you opportunities to manage property for tenants and collect rent. Let’s say you purchase a property for $300,000 and you have monthly mortgage payments totaling $1,800. If you charge tenants $2,400 per month in rent, you’ll make more than enough to pay your baseline expenses, plus the cost of repairs and maintenance. This means your loan could be a gateway to a steady stream of income.
- Access to tax breaks. There are several tax breaks for which homeowners can qualify. A loan that allows you to buy a house you otherwise couldn’t afford would enable you to save substantial amounts on your tax returns.
The bottom line is that home loans are often good debt – but this isn’t always the case. There are several essential caveats:
- You need a long-term plan. You can’t buy a house and simply assume it’s going to pay off. You have to have some kind of long-term plan. Are you going to stay in the house for 10 years and wait for it to appreciate? Are you going to rent it?
- Your purchase price needs to be fair. Overpaying for a house will saddle you with excessive debt and fewer financial opportunities. Try to get a good deal on your property.
- Your mortgage payment should be affordable. Your monthly mortgage payment also has to be affordable. If you can barely make payments each month, a home loan will hurt your finances more than help them.
- Your interest rate, terms, and conditions should be reasonable. Not all home loans are the same. Your interest rate should be reasonably low and fixed; you also shouldn’t incur hidden fees.
- You need to keep the property in good condition. Your residence is a valuable investment, so you should treat it accordingly. If you allow its condition to decline, the value of your asset will drop as well.
Are you ready to take the plunge and start shopping for a mortgage for your first home purchase? Or are you looking to add more rental properties to your real estate portfolio?
Green Residential can help. Contact us today for more information or a free consultation!