Is There Really “Good” Debt?

We often hear about or see articles referring to something called “Good Debt”, and if you’re like me you wonder how any kind of debt could be considered good. Credit card debt, loan debt, household debt, and the national debt get plenty of negative headlines and rightly so, but what might be considered good debt?

For debt to be good, it would have to provide a benefit that outweighs the burden of carrying the debt. This includes the affects that debt has on our emotional and physical state, as well our finances. Long after a purchase is made, debt is like a taskmaster. It demands to be paid first (and usually with interest), and it demands to be considered first in all of our financial decisions and planning. So how could debt ever be considered a good thing?

It’s true that borrowing allows us to buy things that we couldn’t otherwise buy, like the purchase of a home, education costs, or an unexpected medical expense. But many people borrow to buy a lot of things that they wouldn’t buy if they couldn’t borrow the money or use a credit card. Then as the payments are stretched out, the interest on the debt adds to the burden. So what is good debt?

Mortgage Debt

One of the most popular “Good Debt” topics is a mortgage, with a focus on the tax deduction associated with mortgage interest. There are many good reasons to buy a house, but being able to deduct mortgage interest shouldn’t be high on the list. We have to remember that mortgage interest for tax purposes is a deduction not a subtraction, and that it’s determined as a percentage based on our income tax bracket. The tax brackets for 2013 are shown below for reference (click on the image for a closer look).

2013 Tax Brackets

For example, a married couple with $82,000 in taxable income would fall within the 25% tax bracket. If they own a home with a mortgage, for every $1.00 that they pay in mortgage interest they would receive a $0.25 tax benefit. The other $0.75 of the dollar is gone. Here’s how this works. First we’ll calculate their income tax without the mortgage interest deduction.

Taxable income x Tax bracket = Income tax
$82,000 x 0.25 = $20,500

Now we’ll determine their income tax with the mortgage interest deduction. If we assume that their mortgage interest for the year is $5,800, this amount is subtracted from their taxable income (not their taxes). Then their income tax amount is calculated using the adjusted taxable income as shown below.

Taxable income – Mortgage interest paid = Adjusted taxable income
$82,000 – $5,800 = $76,200

Taxable income x Tax bracket = Income tax
$76,200 x 0.25 = $19,050

The difference between the income tax amount without the deduction ($20,500) and the amount after the deduction ($19,050) is $1,450, which is 25% of the mortgage interest paid.

Mortgage Interest paid x 25% = tax savings from mortgage interest
$5,800 x 0.25 = $1,450

Even though the couple in the example paid $5,800 in mortgage interest, the tax benefit is just $1,450. The deduction for property taxes is calculated the same way and has the same affect. There is a tax benefit, but not to the extent that many people think. And even though we get some of it back, wouldn’t it be great to not pay it in the first place. With this in mind, I wouldn’t call a mortgage (or any other debt) good debt. To me, the only good debt is no debt.

For methods to eliminate debt, see my earlier post 4 Ways to Eliminate Debt.

Historical note: When credit cards were first introduced, the interest charges paid on the balance were tax deductible. This was an incentive to get more people to use them. A few years later when credit cards had become popular, this deduction was eliminated. On several occasions, Congress has considered eliminating or modifying mortgage interest and property tax deductions as well. Although this would be extremely unpopular, it has been considered so keep an eye out for changes or check with your tax professional.

*All of the calculations were performed using Jazer 100 Personal Finance software.

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