Good Debt and Bad Debt: Borrowers Are Better Off When They Know the Difference

    Debt is truly a double-edged sword — a blessing when used thoughtfully and selectively but a curse when overused and relied upon indiscriminately, says FPA member and CERTIFIED FINANCIAL PLANNER™ professional Devin Pope of Albion Financial Group in Salt Lake City, Utah. “There is good debt, when it’s used as a positive tool that enables a person to acquire assets or skills that ultimately improves their financial standing, but that would otherwise not be attainable with capital on hand. That kind of debt generally makes sense for a person to carry on their balance sheet.”

    On the flip side, there’s bad debt. That can be when a person takes on debt — and the extra cost typically associated with it, known as interest — without the means to pay off the debt in a timely fashion, according to the agreed-upon terms attached to that debt. Bad debt also can be debt a person takes on unnecessarily, when they could just as easily have used cash on hand to pay for an item rather than assuming the extra financial burden that interest brings, or simply if a person assumes additional debt to make what is clearly a frivolous, unnecessary purchase. Or it can be debt that a person takes on for the right reasons, but without adequate due diligence. Getting a mortgage makes good sense for a person acquiring a home, for example. But if that person could easily have found a mortgage with a significantly lower interest rate simply by shopping around a little, then their decision to accept the higher rate, and the tens of thousands of dollars in extra interest payments it may cost them over the life of the mortgage, turns that loan into something less than “good debt.”

    With so much potentially at stake, anyone who’s either already a borrower or considering taking on debt in some form, via a car or student loan, mortgage, line of credit, credit card, etc., should have a clear understanding of the distinctions between good debt and bad. Here’s a look at the two sides — financially constructive and financially destructive — of debt. For advice on how to get the most out of the former and avoid the latter, or for help figuring out how to better manage debt or resolving a debt issue, seek out the support of a CERTIFIED FINANCIAL PLANNER™ professional. To find one in your area, consult the Financial Planning Association’s searchable national database at

    Good (financially constructive) debt

    Generally, student loan debt is constructive debt “because it enables you to acquire skills or knowledge that give you the opportunity to make more money,” says Pope. Essentially you’re investing to improve the value of your own human capital. Too much student loan debt can negate that added value and turn good debt into bad, however. More on that in a moment.

    A home mortgage also generally falls into the good debt category, Pope says, pointing to the tax breaks that often accompany a mortgage, as well as the potential for that home to appreciate in value over the long term, which can make it a wise investment. Not all mortgage loans are created equal, however. More on that later, too.

    Zero-interest offers on car loans, credit cards, etc., can represent a positive use of debt, provided the person assuming the debt takes advantage of the zero-interest benefit. Zero-interest means a loan or credit card charges no interest (often for a period of time). In the credit card scenario, transferring a balance on a higher-interest card (many cards carry rates of 10 to more than 20 percent) to a zero-interest card can save hundreds, even thousands of dollars. A zero-interest auto loan also can save a person significant amounts of money in interest over the life of the loan. With such a loan, it might also make sense to use less money for the loan down payment at the time of purchase and use the money for another constructive purpose, such as to apply it directly to the balance owed on a high-interest credit card, for example. Essentially, you’re taking on more debt, but at no additional cost (interest), which in turn frees up funds to pay down a debt that will mount (compound) much more quickly because of the higher interest rate. That money also can be used to build an emergency savings fund, or to invest in a retirement plan, notes Pope.

    Sometimes Good, Sometimes Bad Debt

    Credit card debt generally is neither good nor bad, says Pope, it’s merely a tool that increases a person’s purchasing power. But that comes with one big caveat: The credit card holder must commit to paying off all or most of the card balance each month. By doing so, they not only avoid running up a large and mounting balance (due to compounding interest), they build their credit score as a result of their positive payment track record, which in turn helps to secure lower rates on a mortgage, car loan, etc. — compound benefits, if you will.

    On the other side of the coin, failing to pay down credit card balances in a timely fashion can quickly turn credit card debt into bad debt. The balance on a credit card that carries a 20% interest rate can grow unexpectedly fast, creating a debt hole that can be difficult to climb out of.

    Bad (financially destructive) debt

    “Bad debt,” explains Pope, “is debt that has no future benefit.” For the debtor, bad debt not only lacks any benefit, it also can bring serious and lasting financial headaches.

    Debt taken on for purely discretionary reasons — vacations, an upgrade to a better TV, etc. — generally is bad debt, says FPA member Scott A. Bishop, CFP®, of STA Wealth Management in Houston, Texas. “If these things are important to you, save up your money and cut back expenses elsewhere and save up. Then use your cash to pay for it.”

    Credit card debt can turn destructive particularly when the person carrying that debt lacks the cash on hand to pay off card balances in full or almost in full each month. Given the high interest rates that many cards carry, those balances can quickly escalate (due to compound interest) and become problematic.

    Credit card debt often becomes a problem for people who rely on plastic to cover basic expenses. In a recent poll, CNBC Make it found that for almost one-quarter — 23% — of Americans, basic necessities like rent, utilities and food contribute most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt. Using credit cards to cover basic household expenses should be an absolute last resort, says Pope.

    A lack of awareness could be part of the problem. In a separate survey by U.S. News & World Report, 21% of consumers didn’t know if they have debt and 30% were unaware of how much credit card interest they pay each month. Meanwhile, 24% were found to be carrying credit card balances exceeding $10,000. Among those polled, 13% say credit card debt causes them to struggle to make ends meet.

    Too much student loan debt can turn into bad debt, especially in cases where a person, once they leave school, lacks the earning power to pay down their debt obligation or are so financially hamstrung as a result of that student loan debt that they can’t meet other basic financial obligations, such as covering monthly expenses.

    A home mortgage also may fall into the “bad debt” category, in cases where an individual or couple take on more debt than they’re comfortable assuming or capable of paying off. Psychologically, carrying a certain level of debt can create undue stress for a person or a relationship, for example. In others, a mortgage debt may push a couple or individual too close to the margin financially, where an unexpected large expense or development (such as a lost job) can render them unable to meet their debt obligations. Committing to an adjustable-rate mortgage, where the borrower assumes the risk that the interest rate on the loan may fluctuate and potentially increase significantly, burdening them with much higher payments, can also be a form of bad debt, particularly if the individual or couple hasn’t taken steps in advance to ensure they can cover those potentially higher payments.

    In cases such as these, debt does indeed become a four-letter word, rather than a constructive financial force in a person’s life.

    September 2019 — This column is provided by the Financial Planning Association® (FPA®) and FPA of Iowa, the principal membership organization for Certified Financial PlannerTM professionals. FPA seeks to elevate a profession that transforms lives through the power of financial planning. Through a collaborative effort to provide members with tools and resources for professional education, business support, advocacy and community, FPA is the indispensable resource in the advancement of today’s CERTIFIED FINANCIAL PLANNER™ professional. Please credit FPA of Iowa if you use this column in whole or in part. The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION.  The marks may not be used without written permission from the Financial Planning Association.


    The Health Savings Account: A Powerful but Oft-Overlooked Asset for Retirement

    Some 15 years after the U.S. government established health savings accounts to give people a tax-favored vehicle to pay for medical and healthcare expenses, the HSA remains “the best deal in the tax code,” according to CERTIFIED FINANCIAL PLANNER™ professional and FPA member William M. Harris, cofounder of WH Cornerstone Investments in Duxbury, Mass.

    That deal comes in the form of “a compelling mix of tax breaks and other savings that can keep [HSA account owners’] health insurance costs down,” explains FPA member Peter Lazaroff, CFP®, co-chief investment officer at Plancorp in St. Louis, Mo. “But under the right circumstances, these accounts offer an even more powerful — and largely underappreciated — chance to boost your long-term savings and provide a nest egg to offset the rising cost of health care later in life.”

    Established as part of a federal tax law that took hold in 2004, HSAs are available to people who participate in a high-deductible health plan. The compelling mix to which Lazaroff refers begins with a triple tax advantage:

    1. Contributions to an HSA net the contributor a current-year tax deduction (of up to $3,500 annually for an individual and $7,000 for a family in 2019).

    2. Any earnings or growth in the value of funds in the account are tax-free.

    3. Funds withdrawn from the account come out tax-free if they are withdrawn according to HSA rules and are used for qualified healthcare/medical expenses.

    While those tax advantages certainly can be useful to the many people who contribute to an HSA and use funds in the account to pay healthcare and medical expenses on an ongoing basis, it’s the longer-term possibilities to which Lazaroff refers — the widely underappreciated aspects of the HSA — that make it a particularly appealing tool for people saving for retirement. Funds in an HSA can be used to cover qualified healthcare and medical expenses at any stage of a person’s life, including retirement, when they can be used to cover Medicare premiums, long-term care insurance premiums, long-term care expenses and day-to-day costs, from copays to prescription drugs to high-priced surgeries.

    Those costs can add up over time, particularly during retirement, when people generally are more apt to need health care. According to Fidelity Investments, the average retired couple age 65 in 2019 may need about $285,000 saved (after tax) to cover healthcare and medical expenses in retirement. That figure is in today's dollars and excludes potentially expensive long-term care.

    So rather than using the HSA mainly as a revolving account to cover qualified expenses in the short-term, there’s merit to the owner of the account instead using it as a long-term savings and investment vehicle, similar to an IRA (individual retirement account), contributing as much as they can to the HSA (up to the allowable yearly limit). Instead of using that money to cover near-term expenses over the course of a given year, they pay all or most of their medical/healthcare expenses out of pocket, thus leaving money in the account, where it can roll over from year to year, and where it has the opportunity not only to accumulate but to grow in value. To give HSA account owners access to upside potential, many HSA providers offer IRA-like mutual fund investment options in addition to a base savings account.

    An HSA “can be treated as an IRA in that balances can roll from year to year, they can be invested in most any type of marketable security, and their annual contribution limits are substantially higher than an IRA,” explains James H. White, CFP®, who heads J.H. White Financial in Pottstown, PA.

    That’s when an HSA becomes much more than just a tax-friendly revolving account and begins to function more like a long-term tax-favored retirement asset. Using such an approach, “You can walk into retirement with a nice, healthy pot of money to use for healthcare expenses,” says FPA member Cathy Gearig, a CERTIFIED FINANCIAL PLANNER™ professional with LifePlan Financial Advisory Group in Rochester Hills, Mich.

    The longer the HSA owner follows that approach, the more time the money in their account has to grow. “If you begin maxing out [annual HSA contributions] at an early age, you can benefit from tax-free compound earnings for a long period of time, says FPA member Jake Northrup, CFP®, of Ballentine Partners in Boston, Mass. “This not only reduces your tax bill in the year of contributions, but creates a powerful investment vehicle that you can specially earmark for future medical expenses. With medical costs and life expectancy rising, this can be a very important strategy to utilize.”

    Such a strategy works in large part because of the triple tax advantage associated with the HSA. Contributions, any growth inside the account, and distributions (withdrawals) from the account, when used for qualified medical/healthcare expenses, are all tax-free. “By investing your HSA savings as you would your retirement savings — typically in a diversified mix of mutual funds and [exchange traded funds] that offer the opportunity for long-term growth — you’ll build a tax-free fund dedicated to health costs in retirement, which are likely to represent a significant portion of your future budget,” says Lazaroff. “The chance to add another pool of tax-deferred money to your retirement savings is an advantage you shouldn’t ignore.”

    Leading up to and during retirement, the funds inside an HSA always can be used, tax- and penalty-free, for medical/healthcare expenses. When the account holder hits age 65, the restrictions on how those funds can be spent lift, and HSA funds can be used for any purpose, without the account owner incurring a penalty (although they will have to pay income tax on distributions that aren’t used to cover medical/healthcare expenses). Also come age 65, account owners can use HSA money (again on a tax-free basis) to pay premiums on Medicare and certain kinds of insurance, such as long-term care insurance.

    How much of that pool of HSA money a person decides to allocate to IRA-style equity investments (tied to the stock market, generally) and how much they opt to keep in a more conservative traditional fixed HSA vehicle depends on a person’s risk tolerance, and the extent to which they’re using the HSA not only as a long-term investment tool but also to cover near-term medical/healthcare expenses, notes Gearig. People who expect to pay near-term expenses out of the HSA may want to allocate more conservatively by keeping money in a savings-type HSA account, where it can’t lose value, knowing they may need to access that money soon, while also maintaining an investment portion of the HSA to access long-term growth potential, knowing the value of that investment allocation likely will fluctuate along with movements in equity markets. “It’s a good idea to treat the investment component of the HSA like you would funds in an IRA — more hands-off,” she advises.

    As Gearig notes, not everyone has the cash flow required to both fund an HSA and cover all or most of their medical/healthcare expenses out of pocket. “That’s certainly not possible for everyone,” she says. “It really depends on the stage of life you’re in, and what you’re cash flow picture looks like.”

    Regardless of the stage of life, it’s worth considering contributing to an HSA, and if cash flow permits, leaving at least some of those funds in the account as a long-term investment for retirement, because, as White points out, “Every dollar you can put in an HSA and save for retirement health care expenses will take some stress off of your other retirement accounts.”

    June 2019 — This column is provided by the Financial Planning Association® (FPA®) and FPA of Iowa, the principal membership organization for Certified Financial PlannerTM professionals. FPA seeks to elevate a profession that transforms lives through the power of financial planning. Through a collaborative effort to provide more than 23,000 members with tools and resources for professional education, business support, advocacy and community, FPA is the indispensable resource in the advancement of today’s CFP® professional. Please credit FPA of Iowa if you use this column in whole or in part. The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION.  The marks may not be used without written permission from the Financial Planning Association.