- The two main types of debt are Secured and Unsecured.
- The interest rate received and the tax deductibility of the interest are two primary ways to evaluate the quality of debt.
- It is hard to retire with a large amount of debt, so we typically recommend clients avoid most, if not all, types of debt.
Debt can be very intimidating for most individuals, and rightfully so. However, if left unchecked, debt can snowball to a level that will prevent all discretionary spending and savings. In these cases, the power of compounding interest works against you as debt will grow and accumulate exponentially if appropriate payments are not made. Our goal for this blog is to provide a high-level overview of the different types of debt and when one may be more preferential than the other.
Types of Debt: Secured vs. Unsecured
First, it is essential to know that there are two main types of debt: Secured and Unsecured. Secured essentially means some assets are put up for collateral in case the debt payments are not made. For example, a mortgage is an example of a secured debt because the home is used as collateral. A car can be repossessed if payments are not made, so auto loans are a form of secured debt. Credit cards are unsecured since this debt is backed only by the debt-paying ability of the individual. Since secured debt has a collateral component, the bank considers this a lower risk since they can always retrieve the physical property. Because of this, secured debt tends to have a lower interest rate associated with it. The unsecured nature of credit cards is why they may have interest rates as high as 20% at times.
Evaluating Debt: Interest Rates and Tax Deductibility
The tax deductibility of the interest payments is also important to be aware of. Some forms of debt will allow you to receive a tax deduction for the interest payments that have been made over the year. Two of the most common examples of this are mortgage and student loan interest payments. Obviously, it is preferred to have debt that has a tax-deductible interest. This would lower the debt’s overall net cost since you would benefit from saving on taxes.
Non-Traditional Sources of Debt
There are two other sources of debt that we wanted to cover that may be considered non-traditional. First, we do not want to miss the 401(k) loan concept. These are great tools if needed since the principal and interest payments would be paid back into the retirement account. This route possibly has the lowest cost of debt since you are essentially making a loan to yourself. There are limits on the loan and other restrictions to be aware of, though, if you are attempting to transfer or rollover an account with an existing loan.
Lastly, we know there are times when loans happen between friends and family. While these loans may never go on paper, and often no interest is charged, we want to warn our clients against pursuing this route. Loans between people who are personally close to one another can lead to additional stress on the relationship. This stress is sometimes strong enough to split two people apart, and we do not believe any scenario is worth the possibility of that outcome.
Retirement and Managing Debt
To afford retirement, we typically steer clients away from debt. The interest payments can drain discretionary income and prevent savings that may have accumulated over time. Plus, debt payments throughout retirement may be tough to afford if the individual lives off a limited income stream such as Social Security, Pension, or Annuity benefits.
Debt can also be very challenging from a mental or emotional perspective. It is not easy to know that you owe others money, which could cause you to lose sleep at night. For all of these reasons and more, we tend to pursue other alternatives rather than taking on debt. Of course, debt cannot always be avoided, and it may actually be advantageous when interest rates are low. This is why we always review our client’s specific situations before we recommend any course of action.
Speak With a Trusted Advisor
If you have any questions about Behavioral Finance, taxes, your individual investment portfolio, our 401(k)-recommendation service, or anything else in general, please call our office at (586) 226-2100. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Zachary A. Bachner, CFP®
with contributions by Robert L. Wink, Kenneth R. Wink, and James D. Wink
If you found this article helpful, consider reading:
- Understanding Behavioral Finance
- Tax Filing Status Options Explained
- Acceleration and Deceleration for Investors
- Tax Loss Harvesting