Is debt a friend or foe?

August 7, 2012 

Debt certainly has its necessary uses. Some things in life just can't easily be bought outright for cash. However, I think we can all agree that the expanding uses for debt and easy access to it greatly contributed to our country's economic fall of 2008 and 2009. Recent census data tells us that one-third of Americans 65 or older today carry a mortgage and average credit card balances of around $10,000. You don't have to be completely debt-free before retirement, but too much or the wrong kind can really hurt your standard of living and your chances for comfortable golden years.

As a financial adviser, I frequently am asked by clients to help them make wise decisions about different types of debt. Is it a good idea to finance or buy something

outright? What about the terms and length of different loans? Is refinancing a mortgage a good idea? These are all important questions. I covered this topic briefly in a book I contributed to last year. I'd like to give our readers some tips on how they should approach thinking about debt.

What kind of debt is good? Many people have the misconception that if something can be bought on credit, it's OK to buy it. This is certainly what the credit card companies would like you to believe! Typically, debt should only be used for the purchase of something that has the reasonable ability to increase in value. Examples of this would be a home, educational expenses or a business.

On the opposite side of the spectrum we have debts taken out to purchase items that decline in value or have very little to show for them. Examples are credit cards, retail charge cards, auto, boat and motorcycle loans. I'm not saying they are inherently bad. I'm just pointing out that these debts show no return and often end up costing money rather than making money.

But many folks will rationalize themselves silly to buy something they don't need with money they must borrow to impress people they don't even like.

As a rule of thumb, during your working years, you should strive to keep your mortgage debt below 25 percent of your gross income; other debt should stay below 10 percent. In retirement, the best case scenario is to have no debt whatsoever. It is much easier to live on a fixed income supplemented by investments if all you have to pay for is your health insurance and basic living expenses. A lofty goal to strive for is having no debt before you start your retirement.

Of course, it's preferable to never take on those bad debts. But what if you have some of these bad debts now? You want to try and get rid of the worst debts first. Loans or credit cards that carry the highest interest rates should be your initial focus. Use money from savings or tax returns to wipe these out as soon as possible. Some folks also will transfer balances to lower interest cards while they pay them off. Next, focus on other bad debts that carry high rates, aren't tax deductible and likely lose value like auto loans.

Many folks also would like to speed up the payoff on their mortgage. But, be careful about getting too aggressive with prepayments on your home loans especially if you've refinanced or bought a home lately and you have a very low rate. You may be able to get a higher return if you invested the money and your mortgage interest deduction would be lost after paying it off. If you can get in the habit of making one extra payment per year, it will significantly reduce the interest paid and life of the loan while allowing for other savings goals.

Knowing the difference between good and bad debts is the first step to making wise decisions about purchases. Having a debt reduction and elimination plan will allow you to feel in control of your financial future. Going into retirement with no debt will give you the freedom to pursue those things that mean the most to you. The liberation of not owing anyone anything is a major accomplishment we can all strive towards.

Kris Flammang, co-founder of LPF Financial Advisors, can be reached at 941-907-0101 or kflammang@lpfadvisors.com.

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