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Efficient Debt Versus Inefficient Debt

Avoiding debt in today's society is almost impossible for most working Americans—particularly if you want to buy a home, a car, a business or any other big-ticket items. But some debt is better than others.

Perhaps the worst kind of debt is consumer debt—money you borrow to pay for consumer goods such as boats, television sets, video games and electronics, and even the family vacation. The problem with consumer debt is that the ultimate price of that purchase continues to rise because you have to pay interest on that debt. And as your cost rises, the value of your purchases continues to decline.

By contrast, if you use debt to buy a house, that house may continue to increase in value. Unfortunately, in recent years housing prices have declined sharply, which has been a disaster for many homeowners with steep mortgages. But in normal economic times, mortgage debt is considered one of the more favorable forms of debt.

Here are some examples of efficient debt:

• Self-improvement and education. If you need to borrow money to take a class or earn a degree that will enhance your earnings potential, that's considered efficient debt. You're investing in yourself in a way that will pay off later.
• Business. If you need to borrow money to start a business or buy a business, you should be able to earn a living from that business while covering the cost of your debt. That is considered an efficient form of debt.
• Investment. If you can buy an investment that will earn you more money than the cost of paying off your debt, that's also considered efficient debt.

Home equity loans

If you do need to borrow money, one option for those who own a home is to use a home equity loan.

Typically, home equity loans have a low interest rate, a long amortization period and, in most cases, they are tax-deductible.

On the other hand, one of the worst forms of debt is credit card debt. When you run up thousands of dollars in credit card debt, you could be buried under that debt for many years. Typically, credit cards charge high interest rates, and in many cases, those interest payments are not tax-deductible.

15- or 30-year mortgage

Although it may seem like a 15-year mortgage would be a more efficient mortgage than a 30-year mortgage because you can pay it off twice as fast, there are some advantages with a 30-year mortgage.

For one thing, a 30-year mortgage gives you more flexibility. You may not be as strapped each month to make the mortgage payment. But even if you can easily afford the 15-year mortgage payment, you might still be better served to choose a 30-year mortgage.

With the lower payments of a 30-year mortgage, you will have more money available each month to invest. By investing the difference in the monthly cost between a 15-year mortgage and a 30-year mortgage, even a modest return would earn you enough money to make a balloon payment on the 30-year mortgage after 15 years. Or you can keep your investment growing while you pay off the 30-year mortgage. Either way, taking a 30-year mortgage gives you more options without a significant difference in cost.

Debt may be a four-letter word, but some types of debt are a lot better than others.