Good Debt, Bad Debt: Little Secrets About Borrowing

Aug. 10, 2011— -- Now that the U.S. government's credit rating is less than perfect for the first time, debt is suddenly a hot topic. Public awareness of the nation's fiscal woes has been rising since Standard & Poor's (S&P) downgraded the nation's credit rating a notch because of the ballooning national debt and the inability of a dysfunctional Congress to fix it.

Credit ratings are based not just on the record of paying debts, but also on what rating agencies know about the government, business or person. This summer, Congress showed the world an amazing spectacle. Bemoaning the mounting deficit, some congressmen refused to authorize an increase in the debt ceiling – a move necessary for the government to pay its bills. This is kind of like calling your credit card company and telling them you won't be making any more payments because you're tired of being in debt.

As vice president, Dick Cheney famously said that "deficits don't matter." But of course Cheney was wrong, as shown by the stock market's steep fall triggered by the government's ability to deal with the debt crisis. Today, no one is arguing that the current budget deficit of about $14.9 trillion is a good thing. The more debt the government has, the more it must tax citizens just to pay interest.

Building up too much debt can have disastrous financial consequences for a nation. A current example is Greece, which is borrowing heavily from its European neighbors and undertake austerity measures so severe there have been riots.

Yet without some debt, governments can't assure a sound infrastructure, an efficient transportation system or an educated workforce – items essential to a sound economy. Businesses need to take on debt because without it, they can't achieve their growth goals. Huge companies like Exxon Mobil routinely have billions of dollars of long-term debt on their books because they need cash on hand to meet potential needs and to take advantage of opportunities.

While debt sustains large companies, it also helps small businesses to get started and grow. Fledgling companies often use a combination of loans and venture capital to pay workers and expenses, and they incur debt to fund initiatives long after they become profitable.

Since early in the 20th century, debt has been part of the personal finances of the average American – and for good reason. We go into debt for big-ticket items because this is the only way we can get them without decades of deprivation. The government gives us tax deductions on mortgage interest and college loans to improve our standard of living and train our workforce. This stimulates the economy and creates jobs that result in future government tax revenue. Without debt, society as we know it wouldn't exist.

The issue isn't whether to go into debt, but how much and how to handle it. The main goal is to assure that total debt isn't so great – and interest rates, so high – that you can't retire it in a reasonable period of time. Individuals who can achieve this balance manage their finances like a business.

For individuals, there's good debt and bad debt. Good debt is what you take on to buy a house or car. You pay it off on time without too much strain because you've limited the sum total of payments to a reasonable slice of your income – say, about one-third.

Bad debt is generally the kind you put on credit cards and later have little or nothing to show for -- vacations, restaurant meals, shopping trips to the mall. Still worse for your fiscal health is taking out a second mortgage to pay off credit cards instead of, say, remodeling your home. This means a higher monthly payment without any increase in the property's value.

Successfully managing debt begins with avoiding unnecessary spending. Governments, businesses and individuals burdened by too much debt must learn to exercise financial restraint. A lack of restraint led to the current budget deficit – debt that has grown larger from a decrease in tax revenues resulting from high unemployment.

Just as individuals must tighten their belts when income declines, so should the government. Yet congressmen who opposed the debt-ceiling increase confused reneging on obligations (including paychecks for soldiers) with actual debt reduction. This is like eating an expensive dinner and then leaving the restaurant without paying the bill. The point is to not order meals you can't afford.

The opinions expressed here are solely those of Mr. Schwartz.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation to advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be e-mailed at ted@capstoneinvest.com.