New Home Buying: Good Debt vs. Bad Debt

August 4, 2022

Not all consumer debt is bad. While nuances exist, most experts agree that some consumer debt is 'good.' Knowing more about debt when you're looking to purchase your first home or a new construction home is wise. Hopefully, this article will help teach you about debt and get you a few steps closer to a mortgage approval letter.

You may be tempted to pay off all your consumer debt before buying a new home, especially if it's move-in-ready and fully loaded. We wouldn't blame you if you did. That said, responsibly managing 'good debt' while ridding yourself of 'bad debt' can increase your wealth over time. A little bad debt won't destroy your mortgage approval odds.

Bankruptcy Law defines consumer debt in Title 11 U.S.C. § 101 as "debt incurred by an individual…for a personal, family, or household purpose". Federal law and most states primarily consider any other debt as non-consumer debt or business debt. Lenders do not consider all consumer debt 'bad' though. Equally, they don't assume all consumer debt is 'good.'

Debt Mortgage Lenders Consider

Mortgage lenders generally look at all good and bad debt, with exceptions to certain obligations when applying for a government-backed loan.

Lenders need to know your net worth and debt-to-income ratio before approving your loan for a new house. Homebuilders do too. Both have resources that help you with questions, tell you about their lending and homebuying process, and help set your expectations.

For example, some states regard student loan debt as non-consumer business debt or 'good debt.' Lenders will still count this debt when determining your net worth and D.T.I. ratio.

Likewise, lenders may consider medical debt in their decisions on privately backed mortgage loans, even though the government categorizes medical debt as 'non-consumer debt.'

Government-backed loans, such as F.H.A. loans, are prohibited from counting medical debt towards overall debt when determining D.T.I. ratios. They can include it when determining your net worth, however.

To keep your debt manageable and maximize your mortgage approval odds, ensure your overall debt does not exceed 36% of your pre-tax income. In short, for better approval odds, keep your monthly debt below 36% of the amount of money you make.

How Can Debt Be Good?

Debt can be good if you are going in the hole a little bit now for financial gains at a future date. These gains should cover the principal and interest of the debt and a profit or tax advantage. That's why some consider student loans as good debt. You invested in education to further your career and earning potential.

What is Good Debt?

As a rule of thumb, if you can include the debt on your tax returns, you are dealing with good debt. Examples include:

  • Home Mortgages: Consumers who itemize can deduct property taxes and interest on a home mortgage on a tax return. Although by definition, this consumer debt, your home will likely increase in value, providing you a return on your money—good long-term debt.
  • HELOCs: Another example of good debt is a home equity line of credit (HELOC) for home improvements. A HELOC, when used for home improvements, increases the value of your asset – your home – and provides for higher future income potential. Be careful when considering a HELOC, though – if you cannot make those payments comfortably, you could lose your home.
  • Student Loans: As mentioned above, student loans are also considered good debt. By taking out a student loan, you are improving your odds of better future income. According to a recent Georgetown University study, college graduates earn 66 percent more over their working years than those with only a high school diploma. A student loan is an investment in your future that eventually increases your net worth.
  • Small Business Loans: Even though you cannot deduct the taxes on small business loans, they are considered good debt. With a good business plan and a solid team, the business loan is an investment in increasing your future income.

Too much of a good thing can still be harmful, so ensure your good debt is manageable while eliminating and avoiding bad debt. Lenders won't care if your D.T.I. is 50% and all 'good debt.' They don't know when you will make more from your new business plan or the degree you are working to earn. Good debt is still a monthly bill. If you want to purchase a home, keep all debt below that magic number 36.

How Can Debt be Bad?

Mortgage companies do look at net worth, among other considerations. Net worth tells lenders how much money you have. Bad consumer debt decreases your net worth, usually immediately and semi-permanently. Your net worth drops until you make the difference with more income than you spent on lousy consumer debt.

What is Bad Debt?

As a rule of thumb, if your purchase decreases in value, it's bad debt. Moreover, suppose you cannot write your debt off or it doesn't improve your tax return. In that case, it's bad debt.

Bad debt decreases in value over time and provides no tax benefit.

Use an online financial calculator tool to discover how much your net worth decreases with bad debt. Examples include:

  • Most Credit Card Purchases: While you need to use and pay off a small balance on your credit cards to build good credit, carrying that debt from one month to the next is not good. Consider that a $1,500 vacation at the average existing credit card interest rate of 15% will cost you an additional $426 in interest if you only make the minimum payments. Credit card purchases are among the worst kind of debt.
  • Installment Loans: Some installment loans are bad debt. Suppose you take out a personal loan or installment loan for something that won't increase in value and won't improve your earning potential. In that case, it's bad debt and should be avoided when trying to obtain home financing.
  • Car and Furniture Loans: Cars, furniture, and other consumables that most of us buy with loans depreciate almost immediately. If you must take out a loan, put as much cash upfront as you can, and shop around for interest rates. Work on building your credit to get the best possible rates.

A Word on Debt Consolidation Loans

If you are struggling with finances, taking out a home-equity line of credit (HELOC) is probably not a good idea for debt consolidation. Debt consolidation loans are suitable for bringing down your monthly payment. Still, the interest most people pay over the life of the loan is often more than what they would have paid had they paid each bill separately. You could risk losing your home if you are already struggling with finances.

Avoiding Bad Debt

If you need to build credit or restore your credit rating, taking out a new store card or credit card may be inevitable. You can avoid accumulating lousy debt by carrying a small balance on your cards and paying them off in full each month. Always pay cash for things like cars, furniture, and vacations. A get-around beater car to which you own the title is much more relaxing to drive than a convertible Mercedes with burdensome payments.

Resolving Bad Debt

Suppose you already have plenty of bad debt and not enough good debt. In that case, you may need to resolve some of this bad debt before you can start building the good kind that will increase your net worth and improve your chances of being approved for a mortgage. The steps below outline one way to accomplish this:

  1. Cut Spending: If you don't love it, don't buy it. If you don't need it, don't buy it. Take the money you would have spent on something, even as small as a cup of coffee, and put it in a jar or savings account. A dollar here and there at the convenience store or coffee shop can add up to the cost of another monthly bill! Use these savings to pay down your loans and credit cards as described below.
  2. Pay down Credit Cards, Loans: If you are already deep in loan and credit card debt, many consumers have found success with the snowball approach to paying off loans. Make the minimum payment on all accounts except the one with the highest interest rate. Use the money you saved from Step 1 above to increase what you usually pay on that account until you have paid off this first account. Then, take that same payment, and apply it to the credit card or loan with the next highest interest rate. Repeat until you have paid off all cards and loans.
  3. Set Reminders for Due Dates: Have text alerts and emails sent when your payments are due. Take the time to log into your account online to set this up. Suppose your credit card company or bank doesn't offer text alerts. In that case, you can set up your email to notify you when specific senders send you an email. Or use the reminders on your phone or calendar to alert you when payments are due. Include how much you owe and the phone number to call, website to visit, or payment address in the reminder notes.

Conclusion

When considering going into debt for something, consider whether your purchasing will increase in value and your overall net worth over time. If it will, this is 'good' debt. If the item decreases in value or your overall net worth over time, it is 'bad' debt.

While mortgage lenders will look at both good and bad debt, incurring a little bit of 'good' debt and resolving and avoiding 'bad' debt will help you secure a mortgage. Living by the good debt vs. bad debt principles is an excellent way to improve your financial position and increase your mortgage approval odds.

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Thomas P
I believe in making the impossible possible because there’s no fun in giving up. Travel, design, fashion and current trends in the field of industrial construction are topics that I enjoy writing about.

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