Key takeaways
Not all debt is created equal; some forms of debt have the potential to help your clients achieve their financial goals.
Forms of debt such as student loans are often considered “good,” while high interest credit card debt is often used as an example of “bad” debt.
A strategic use of debt may help your clients achieve their short- and long-term financial goals.
Americans are no strangers to debt. The average debt balance held by U.S. consumers is $101,915.1 Depending on how and why they’re borrowing, however, debt can be useful.
Whether a given debt is good or bad depends on several factors. There’s the interest rate and the amount of time it will take to pay back the loan. Then there’s the matter of what your client is borrowing the money for. Equally important to consider is your clients unique tolerance for debt.
By and large, good debt is borrowing that helps your client build long-term wealth. Bad debt, on the other hand, can harm your clients credit and deplete their finances. The difference comes down to two factors: risk and cost.
“I would equate bad debt with taking on too much risk without the ability to repay it,” says Cindy Luckman, senior vice president and managing director for U.S. Bank Wealth Banking Services. “Bad debt is either too risky or too costly.”
Credit card debt is probably the most common example of bad debt. The average card balance is almost $6,000 per person in the U.S.2 It’s considered to be a form of bad debt because of its high interest rates.
Car loans are another example of bad debt because they’re used to borrow money to buy an asset that depreciates. In general, Luckman says, “Borrowing to support ongoing living expenses is not a good use of debt.”
Student loans are probably the most common example of good debt, given the correlation between a college degree and higher earnings throughout your career.3 But that’s just the start. “Good debt can help borrowers accomplish an objective or help them avoid a bad outcome,” says Luckman.
When it comes to accomplishing your clients 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 your client knows they’ll be able to make their monthly payment, there is the additional benefit of improving their credit score by making the payments consistently.
Depending on their circumstances and risk tolerance, leveraged investing can be another good debt strategy. Say they’re investing $100 with an expected 10% rate of return. If they invested their own money, they would earn $10. But if they were to invest half their money and borrow for the other half, they could earn more, if the interest on the loan is less than 10%. In this example, says Luckman, “they leveraged their return.”
Another potentially effective debt strategy involves using a loan to diversify their 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 their portfolio is that they may defer paying the capital gains tax they would incur if they sold the concentrated stock.
Luckman relates the story of a client who owed a large tax payment on April 15, well before June when he was expecting to receive a cash payment. The client could have sold off some assets in his portfolio to pay the tax bill, but that would have required reconstructing his portfolio afterward, not to mention paying transaction costs and potentially more taxes. Instead, the client decided to take out a loan to pay the tax bill and then repaid the loan in June. “Avoiding disruption in their portfolio is an example of using debt effectively,” explains Luckman.
Your client may want to consider using income generated from diversified investments to pay down bad debts. After assessing the amount of their bad debts, they may find that it makes financial sense to sell off an asset to quickly pay down their debts. This is where their personal debt tolerance comes in.
Your clients comfort level with a given amount of debt depends on their tolerance for risk. It’s important to understand the downside of taking on debt, so they can determine how comfortable they are with that risk,” says Luckman.
For example, if they borrow to diversify their portfolio, are they willing to ride out a volatile stretch in the market? Also consider their time horizon: Are they determined to pay off an investment-related debt in two years, or would they be okay if it took longer? Questions like these can help them assess whether they feel comfortable taking on debt as a part of their investment strategy.
Luckman says debt tolerance is different for everyone. “They always want to look at their cash flow and make sure they have enough income to service their debt,” says Luckman. “But determining the amount of good debt they should take on is more art than science.”
It’s important your client talks with a financial professional before incorporating debt into their financial strategy.
Leveraging the assets in an investment portfolio through a flexible line of credit can provide quick access to cash.
Consider using leverage as part of a strategic financial and investment strategy.
Equal Housing Lender. Deposit products are offered by U.S. Bank National Association. Member FDIC. Mortgage, Home Equity and Credit products are offered by U.S. Bank National Association. Loan approval is subject to credit approval and program guidelines. Not all loan programs are available in all states for all loan amounts. Interest rates and program terms are subject to change without notice.
