Although living debt-free is a possibility for some, it is not always the wisest financial decision. This may sound counterintuitive, but every financial advisor or debt management company knows that certain kinds of debt are not only unavoidable, but they can be sound financial decisions. When it comes to some of life’s biggest purchases, (like a car, a home, or college), some loans can be considered “good” kinds of debt.
Debt Management: Good vs. Bad Debt
Financial advisors and professionals use the term good debt to refer to an investment that will grow in value or has the potential to generate long-term income for the borrower. Loans that allows interest rates and fees to consume your income on the other hand, are what is considered “bad debt.”
What good debt looks like
Taking out a mortgage to buy a home is usually considered good debt as well. Like student loans, mortgages will typically have a lower interest rate than other forms of debt, and the interest paid on the home is tax deductible. Ideally, the home would also increase in market value over time, which would help a homeowner recoup some of the interest paid over the same period.
However, as our founder Joe Pantozzi points out, the math isn’t always that simple—nor are your options as a homeowner.
Putting Good Debt to the Test
In the following scenario, our CEO and founder, Joe Pantozzi, explains some of the misconceptions clients have about their debt and what ‘good debt’ looks like to many borrowers.
Joe makes the case for managing your mortgage debt
Scenario: A client thinks he needs to maintain some level of home mortgage debt because he believes that his home mortgage interest deduction will defray some of the cost of his income taxes. He thinks this approach is a safe strategy through which he can build his wealth.
“Isn’t paying less for my income taxes always a good thing?”
Although his client’s knee-jerk reaction is to pay less in income taxes, the truth is that it depends on the state of your finances. Let’s look at this scenario a little closer:
Scenario: Thinking that he needs to maintain a mortgage on his home for the income tax savings, this client proceeds to secure a new $ 80,000-first mortgage against his otherwise paid-for home.
For those less familiar with the nuances of the financial industry, this is a financial snapshot of what a 30-year, 360-month fixed mortgage looks like:
Term: 30-year (360-month) Fixed mortgage
Interest Rate: 5%
Loan Amount: $80,000.00
Monthly (principal & interest only) payment: $427.68
Total payments, 12 months: $5,132.00
Total Principal paid 12 months: $1,159.00
Total interest paid during first 12 months: $3,973.00
Joe’s Notes: Keep in mind that this ‘client’ has an earned income of $150,000. He has a non-working spouse and three minor children. He is also subject to California state income taxes and will likely be in the 18.5% federal tax bracket, with the top marginal rate likely to be no more than 25%.
That means the approximately $4,000 interest payment just incurred by this client may lead to a $1,000 “reduction” in his net income taxes.
Know what real good debt looks like
When it comes to leveraging your debt and knowing when it’s “good” or “bad,” a good rule of thumb to keep is to deploy your assets and cash flow where YOU are comfortable doing so, not where others say you should.
Joe’s Notes: Also keep in mind that each financial and legal situation is different; this generic scenario is meant only to shine a light on the need for a thorough understanding of asset and debt management in the establishment of a financial legacy.
Get an insider’s insight: Joe’s cash flow routes
Some financial planners urge their clients to consider precious metals, art, and other collectibles to be assets. However, because they don’t produce cash flow, their dynamism as an asset is limited.
Instead, Alpha Omega Wealth’s own Joe Pantozzi compiled the five routes of cash flow that he used to build his legacy and help his clients with theirs.
Joe, where does your cash go?
- My business
- Owned and controlled real estate, in addition to a private residence (which is not technically an asset)
- The Stock Market
- Whole life policies (where banks and even Fortune 500 companies store money)
Work with Legacy Builders Instead of Salespeople
When our financial advisors work with a client, we build nuanced profiles and financial portraits of our clients, their financial needs, and their financial goals. This summer, we’re offering free seminars where you can learn about debt management, good vs. bad debt, and advice for your filing your income taxes. Learn more today.