Debt Management Breeds Future Wealth

Physician's Money Digest, October15 2003, Volume 10, Issue 19

The Wizard of Oz

In the classic movie , childrenand adults alike learn that there are good witchesand bad witches, even though the connotationattached to the word witch doesn't necessarilyconjure up a pleasant image.

Smart Couples Finish Rich

The same concept is true with debt—there's gooddebt and bad debt. It may sound strange, but accordingto David Bach, CEO and founder of FinishRich,Inc, and author of (Broadway Books; 2002), understanding how toreduce bad debt and maximize good debt can actuallyhelp you build wealth.

The average US household carries a significantdebt load, including a mortgage balance of $69,277, acar loan of $23,065, and a credit card balance totaling$8367. In fact, the average American spends morethan 14% of their after-tax income paying off thatdebt. But the key to making debt work for you is torecognize the difference between good and bad debt.

Good and Bad

Examples of good debt are home mortgages, educationloans, and business- or home-improvementloans. The reason is that these assets appreciate invalue. Consider that an advanced degree can increaseyour earning power by as much as 80%. Businessloans usually lead to a direct increase in revenue, andhome-improvement loans, especially those to improvea kitchen or add a new bathroom, make your homemore desirable and therefore increase its value. And inthe case of a home mortgage, not only do most homesappreciate in value, but also mortgage interest is usuallytax-deductible. Incurring these types of good debtcan help you build wealth in the long run.

Bad debt, on the other hand, is money borrowedfor items that do not improve your financial future.An auto loan is a prime example. Even with 0%financing, the thousands of dollars you are taking onin debt could be better used for an appreciating asset.After all, a new car depreciates in value by about 30%the moment it's driven off the dealer's lot.

Other bad debt loans are those taken for vacations,clothing purchases, and entertainment. In addition,loans for weddings, anniversaries, or other typesof 1-time events are at the top of the list for bad debtpurchases. Consider that the average wedding todaycosts about $20,000, but it takes a full 10 years to payoff. During that time, of course, there is no specificasset that is increasing in value.

Taking Charge

Controlling your debt is critical. Bach suggestskeeping debt payments under 15% of your netincome. To calculate this percentage, total all yourmonthly expenses, and then subtract your mortgagepayments or rent. Divide this figure by your monthlyafter-tax income. For example, if your monthly after-taxincome is $4000 and you have debt payments of$580, your percentage of debt to income is 14.5%.

But don't stop there. Managing your wealth isequally important. For example, how often do youconsider the "real cost" of a purchase? The real costincludes the interest you're paying. Try the calculatorin the Credit Cards section at Bankrate.com to helpfigure out the real cost of purchases.

If you're considering the purchase of an item thatcosts more than $100, wait and think about that purchasefor at least 24 hours. This will help you cutdown on impulse spending. In addition, think of themoney you spend as a series of "either/or" choices.For example, if you purchase an expensive new stereo,you give up dining out for 3 months. Are you willingto make that sacrifice?

Avoiding Tricks

Lastly, beware of debt traps. We've all been luredinto opening up a store credit card account becausethe retailer is offering the incentive of 10% off our initialpurchase. You may be saving 10% now, but moststore credit cards have interest rates as high as 20%.Unless you're very disciplined and pay off balances infull after every purchase, you could end up spendingmore in the long run.

The same is true for 1-year, interest-free purchases.Sure, that new riding mower or stereo system looksappealing, but with many of these interest-free purchasecontracts, if you don't pay off the entire billwithin a year, you could be liable for a sizeable interestpayment on the entire balance. Be sure to alwaysread the fine print.

Taking these steps to maximize good debt andminimize bad debt today could produce significantfinancial rewards in the future.