Are you asking, “Is all debt bad?”
Recently I overheard people talking about being so uncomfortable having debt, they wanted to pay off their home mortgage. Is that the right way to be thinking? Let’s examine why that may not be the case and learn about when debt is “good” and when it’s “bad”.
1. Don’t worry about long-term debt at low interest rates, worry about short-term debt at high interest rates.
Long-term debt, like your home mortgage, can be good. If you enjoy a low interest rate such at 5 or 6%, that is a very attractive rate. There’s no need to rush to pay it off just because it’s debt. At only 5 or 6%, the debt is growing slowly and because most mortgages are for 30 years, you have a long time to pay it off. In a moment, I’ll show you how to pay it off early.
However, short-term debt at high interest rates, such as credit card debt, is what should be paid off. Because it’s at a high rate, it can double and triple in a short period of time. For example, at 15%, the debt balance will double in a little over 4 years.
2. Don’t convert to a 15 year mortgage.
When you change your mortgage from 30 years to 15 years, you lock in a higher payment. This can wreak havoc on your monthly cash flow, especially in a recession. There are other ways to save interest and pay your mortgage off sooner without having to pay fees to convert to a 15 year mortgage and be locked into paying higher payments.
3. Pay extra payments/more principal.
An easy way to pay off your mortgage earlier us to make an extra payment each month. I recommend you pay an extra $100 a month or better yet, take your monthly payment and add 10%, so if your payment is $2,000, add an extra $200 per month. It will result in you making an extra payment a year, which will dramatically shorten the length of time to pay off the mortgage and save you thousands of dollars of interest! Put it on autopay so you don’t have to remember to pay extra each month. Just be sure your bank is crediting it to extra principal.
This will accomplish much the same as going to a 15 year mortgage without incurring fees and being locked into it. For example, if you lose your job, you could stop paying the extra 10% per month to ease your cash flow. But with a 15 year mortgage, your higher payment is locked in. So making an extra payment per year will give you maximum flexibility, a lower payment, and if inflation returns (the pendulum is likely to swing that way long-term), you are paying back with cheaper dollars which is always smart!
4. Roll your line of credit into your first mortgage.
A lot of people have a second mortgage known as a line of credit, which is usually at a higher interest rate. The lowest interest rate will always be on a first mortgage, so if you can roll your line of credit into your first mortgage at a lower, long-term rate, that’s usually a good idea. Otherwise, because your line of credit is usually on a variable rate, your second mortgage’s rate will increase when rates begin to increase. If you wait until rates rise to refinance to a first mortgage, rates on the first mortgage will also be higher! So now is a good time to roll the second into a first mortgage and enjoy the really low rates today.
If you do this, be sure to make extra payments to pay off the debt sooner and don’t incur any new debt!
5. Refinance your debt now.
Rates are at historic lows and now is a great time to refinance all of it to a lower rate and make extra payments. Some people are hesitant to lock short-term debt into long-term debt, so you need to plan to do it right. As a rule of thumb, if you plan to stay in your home a long time (10 or more years), then I would roll the debt into the first mortgage. If you are planning to move sooner than 10 years, then consider paying off the short-term debt and re-fying your first mortgage now.
6. Don’t take on additional real estate debt now unless you’ll have a small mortgage.
This is fodder for another column, but banks own a lot of homes that have yet to go into foreclosure.There are more foreclosures coming, which will likely make real estate prices move lower. This may take a couple of years to work through. Although rates are low and some real estate prices are a lot lower, they can still go lower. In my opinion, now is not the time to take on more real estate debt.
7. Plan to live in your house longer.
It’s expensive to pay commissions to buy and sell homes. When I considered moving several years ago, I realized the real estate commissions and moving costs would total over $100,000 and I could use that money for a nice remodel and stay in the house I already owned!
Real estate prices have stabilized for now. If you have a situation where you owe a little more than your mortgage, it’s even more important to pay extra principal as often as possible to get the principal balance paid down.
8. Realize not all debt is “bad.”
Debt for education or to start a business or buy an asset that will go up in value (appreciate) can be “good” debt. The founders of Google started their business using credit cards, I’d say that was a good use of debt! “Bad” debt is debt used to buy things that go down in value or are consumer items like new cars, clothes, video games, or to take a vacation. They will be worth less or nothing in the future, but the debt will still be there, so it’s not a good use of debt.
Now you know not all debt is bad, it depends on what you use it for. With mortgage interest rates so low right now, consider taking advantage of low long-term rates and be smart with debt!