In today's modern world, few individuals can avoid debt altogether. As you map out your plan toward retirement, it’s important to identify and understand the different kinds of debt you may be carrying.
Yes, there actually is "good" and "bad" debt. Many financial planners advocate the goal of being 100% debt-free by your target retirement date, but there are times when debt can be used as a strategy within an overall financial plan. In the meantime, carrying less bad debt and understanding that good debt may be necessary can help you keep your balance sheet as healthy as possible.
What Is Good Debt?
Good debt is simply borrowing that helps increase your overall net worth. Perhaps the best example of good debt is taking out a home mortgage. Borrowing to finance a home is considered good debt because the residence should appreciate over time. Sure, you pay interest on a home mortgage, but the interest is usually tax deductible, which means you save on your tax bill to Uncle Sam. Plus, assuming it’s your primary residence, you save the opportunity cost of renting a home or apartment.
Another example of good debt can be a student loan, as it’s an investment in your education and thus the potential for higher lifetime earning potential. Borrowing to build or start your own business can be good debt as well, because the goal is to increase your future net worth.
Try To Limit Exposure To Bad Debt
On the other side of the coin is bad debt, which includes borrowing that does not help to increase your net worth or is used to purchase goods that don't have lasting value. The most obvious type of bad debt is high-interest revolving credit. In general, these interest payments are not tax deductible, and the often-high rates can become quite a burden to pay off.
Auto loans can be argued either way. On one hand, reliable transportation can be important to your job security and advancement. On the other hand, a car is a depreciating asset—it tends to drop in value the minute you drive it off the lot. For auto loans, and for any loan, really, it’s important to negotiate the lowest interest rate for the shortest borrowing time.
Create a Debt Strategy
It may help to think about debt as a form of leverage. "You never want to take on more obligations than you’re comfortable with. You should consider whether or not you will have the ability to pay for those obligations in the event either you and/or your spouse become sick, injured, change employment, or pass away. Debt management is a strategy within a financial plan that should be reviewed along with your investments and insurance coverage," says Jessica Landis, director of financial planning at Janney Montgomery Scott.
As you prepare for retirement, now is the time to look at your balance sheet and start making some adjustments. An argument can be made that maintaining some good debt can help you build wealth for retirement.
"Families often focus on paying down their debt prior to retirement instead of focusing on building their wealth to create income to support their monthly expenses. Some households are better served by keeping low-interest debt, receiving the tax benefits, and investing their excess cash flow to achieve a higher long-term rate of return. Essentially it allows clients to leverage their wealth and build more wealth over time," Landis says.
Get Help Making a Plan
Working with a financial advisor can help you map out the best retirement plan for your individual situation. If you are nearing retirement and have debt, review your debt strategy with a financial advisor and develop a financial plan for how to pay for major items such as a new car once you have retired.
"Prior to retirement, many people have the ability to pay for cars and home renovations out of their monthly cash flow or bonuses. Retirees can get themselves into trouble by assuming they can handle major purchases in a similar fashion," Landis says.
Sometimes debt can be a useful strategy, even in retirement. You might spread payments out so you don’t need to take a large lump sum out of your investment or retirement accounts. "This can help with tax management and protect you from taking a lump sum either just before or during a market pullback," Landis says.
Debt doesn't have to be a negative for your balance sheet if it’s used wisely as part of an overall wealth-building plan. But it pays to understand the difference between the good and the bad.
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