Your mortgage. You borrow money to pay for a home in hopes that by the time your mortgage is paid off, your home will be worth more. In some cases, you can deduct the interest on mortgage debt on your taxes. Home equity loans and home equity lines of credit — which are a type of loan in which a borrower uses his or her home as collateral — may also be considered a form of good debt. The interest payments on these are tax-deductible as long as you use the loan for its intended purpose: to buy, build or renovate the home used as collateral.
However, a student loan becomes a bad debt if the loan is not paid back responsibly or within the terms agreed upon. It can also become burdensome if you have so much student loan debt that it takes years and more interest payments to repay.
Auto loans can be good or bad debt. Some auto loans may carry a high interest rate, depending on factors including your credit scores and the type and amount of the loan. Corporate and personal tax rates, which of course vary from situation to situation, significantly affect the attractiveness of debt. To assist companies in building an optimal capital structure, the authors outline a series of questions for CFOs to ask themselves before they establish a debt policy. A decade of high inflation has trapped many chief financial officers between severe financing needs and weakened balance sheets.
The overall deterioration in corporate financial health has been stunning see Exhibit I. Having piled so much new debt onto their balance sheets, they now face sharply higher interest payments as a percent of pre-tax profits.
Worse, since much of that debt is short term, they also face volatile swings in interest rates and heightened refinancing risks. This deterioration has not gone unobserved. Of a sample of companies with a debt rating of A in , had been downgraded by and only 39 had received higher ratings.
Nor is it apparent that these financial pressures will soon ease. CFOs, therefore, often find themselves in conflict with operating managers, who are eager to fund product-market strategies aimed at protecting competitive advantage.
Especially in companies for which equity financing is unacceptable and in which operating management—concerned primarily with production, sales, and marketing—is the dominant force, there is great pressure to leverage the company with an even greater percentage of debt. What is the CFO to do? Is such leveraging worth fighting over?
By way of answer, this article summarizes two decades of research on the use of debt by companies with equity-financing alternatives.
The major finding is that debt financing has in practice a far lower payoff than many CFOs believe. As a result, some of the assumptions of corporate financial policy are due for a careful rethinking. But this enhancement of return on equity is not without cost.
More important, it boosts the volatility of earnings and, by extension, of share price. Absolute profits at the low end of the sales range are much lower when a company uses debt financing than when it uses all equity, but its increase in profits at the upper end of the sales range is much greater in percentage terms.
The reverse is also true: as sales fall toward the low end of the range, the percentage decline in profits is much greater too. Thus, the greater the reliance on debt, the more a high level of sales increases profits—and the more a low level reduces them.
Of course, equity investors ultimately care about such volatility. If the theory is right, moderate use of debt—enough to leverage earnings but not enough to make investors aware of the heightened risk—pays off in a higher value for the company. This traditional theory was challenged by Franco Modigliani and Merton Miller in their landmark article of These arbitrage activities will soon correct any mispricing of the securities and drive them back to equivalence.
This fiscal Garden of Eden is a wonderful illusion, of course; it does not really exist. The source of this largesse is obvious: the Internal Revenue Service. The complication arises from uncertainty about what tax rates to assume. If, for example, all investment income were taxed at the same personal rate, debt financing would remain just as attractive as before.
In the real world, of course, interest and dividends are not taxed alike. For companies that pay no dividends and whose shareholders never sell their stock, the effective personal tax rate on equity income is zero. In practice, these differences in personal tax rates carry a great deal of weight in capital-structure decisions.
The appendix shows this influence at work. Assume a company with expected constant earnings before interest and taxes out to infinity and with a policy of distributing all of its earnings as dividends. Assume a company similar in all respects to the one just described except that it leverages itself with debt, D, borrowed at an interest rate, i, from investors who are taxed on interest income at a rate T pi.
The first term is identical to the funds available for consumption from an unleveraged company. Thus, the value of a leveraged company, V 1 , equal to the value of an unleveraged company, V u , plus the present value of an annual flow equal to iD [ 1 — T pi — 1 — T c 1 — T pe ]. The appropriate discount rate is the rate for flows of equal risk, adjusted for personal taxes, or i 1 — T pi.
These calculations suggest a few general observations. Note also that when the personal tax rate on equity is much lower than that on interest income a condition that is currently built into the U. Finally, note that for a company with no taxable income to shelter, using debt financing actually reduces its value! Member SIPC. Federal Reserve, Consumer Credit, Release Experian, State of Credit iv. Households in " v. Skip to content. Good Debt vs. Bad Debt Understanding the difference.
Our two cents. It pays to pay off debt. It's not all bad Good debt should ideally be in low amounts, low cost, help you achieve your financial goals, and have potential tax advantages. Here are two examples: With mortgages , interest rates are low compared to other types of consumer debt, and owning your own home can help you build wealth over time as well as improve your quality of life.
For example, it could shorten your commute or allow you to move into a better neighborhood or school district. Mortgage interest may be deductible. If you use a home equity line of credit or HELOC for home improvement, you may still be able to deduct the interest if the money is used for improving your residence. As always, be sure to check with your tax advisor. With student loans , rates are comparatively low, and interest can be tax-deductible, depending on your income. Benefits include enhanced career opportunities, which may increase your earning potential in the long run.
How to Pay Off Debt. Debt is one of those things that no one wants to talk about--but we need to, so we can help you manage it wisely. The first thing you'll need to do is arrange your nondeductible debt in order of highest to lowest interest rate. The account with the highest interest is the one you should focus on paying off first.
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