Let's Talk about Debt, Baby!
Let's talk about debt baby. Let's talk about you and me. Let's talk about all the good things and the bad things that may be. Let's talk about debt.
Do I have you humming to a popular ‘90s Salt-N-Pepa tune?
We’ve talked about a budgeting approach and a couple of budgeting systems. Now let’s focus on a related topic: DEBT.
Oh, debt… the inevitable financial reality for many adults in the United States.
Student loan debt. Mortgage debt. Car loan debt. Credit card debt.
How do you feel about it?
If you’re like a lot of people who are carrying some kind of debt, you might feel uncomfortable emotions around the topic of debt. You may experience…
Anxiety. Anger. Sadness. Hopelessness. Overwhelm.
There are so many people who feel as though they will never get out from beneath all their debt.
If this is you, I understand how you feel. I’ve had to sit with those feelings at times. But sitting inside that negative emotional space for too long can cause us to freeze, which leads to inaction… and can eventually lead to even more debt.
So, I want to take this highly emotional topic and look at it objectively, from a higher-level perspective.
My focus in this article will be to break down some preconceived notions about debt and give you some tips on managing debt.
Let’s start with a question.
Can Some Debt Be Good?
Now I know what you might be thinking.
“Um, Deb, obviously there is no such thing as good debt. Debt means you owe money. Isn’t that the opposite of what I want??? Shouldn’t I aim to be debt-free?”
I hear you. Absolutely, it is an admirable and desirable goal to be debt-free. But I have to tell you something. The answer to my question is…
YES.
Not all debt is bad debt. In fact, YES, some debt can be good.
But there’s a catch, as with many other good things. Just because there is some debt that is good doesn’t mean you can let go of responsibility.
You should ALWAYS be responsible when managing debt.
And the responsible way to handle debt is to use it to acquire an appreciating asset. Let me break that down for you a little.
An asset is something you own that has economic value and is expected to benefit you in the future. When you purchase a house, for example, you are acquiring an asset.
Some assets depreciate, meaning that they lose value over time. A common example of this is a car. A used car will almost always sell for less than a new one.
When we talk about an appreciating asset, we are talking about something of economic value that increases in value over time.
So what I’m saying is that when you take on debt, you should use it to obtain something which will continue to increase in value.
This strategic way of leveraging debt takes discipline and focus.
It requires you to balance logic and emotion in order to make the wisest decision. Listening only to the emotional side of your mind can result in taking actions that put you in a worse financial situation. More on that later.
For now, let’s dive a bit deeper into some examples of good debt.
TYPES OF GOOD DEBT: MORTGAGES AND STUDENT LOANS
When you buy a house, you are (in theory) taking on an appreciating asset. This is a “good” kind of debt.
Let’s talk about mortgages first.
Many people can’t afford to purchase a home outright, or entirely with cash. They rely on a mortgage to finance the home purchase. There is no inherent problem with this.
The problems come in when homebuyers…
Purchase a home before they’re financially ready to do so
Don’t save up enough for their down-payment
Take out mortgages with high interest rates when they can’t possibly keep up with required payments
Buying a home is a HUGE decision that requires thoughtful financial planning.
The mortgage debt prevention strategies I recommend are threefold:
Do NOT buy a home until you are on sound financial footing.
Learn how to budget and master your cash flow. Build an emergency fund. Get to a place where you’re able to put some of your earnings into a retirement account. And if you have high-interest credit card debt, pay it off first before you start thinking about purchasing a home.When you’re ready to buy, consider what kind of mortgage best fits your financial situation and goals.
Remember in 2008 when the housing market crashed?
That happened partly because so many homebuyers defaulted on the terrible mortgages that they were stuck with. Unethical behavior was rife within the home mortgage industry leading up to that crisis. Many mortgage lenders were working with shady brokers and saddled unsuspecting people with loans they could never repay.
I won’t even get into the risky stuff Wall Street was doing with all those home mortgages. That’s for another article.
When you decide to take out a home mortgage, do your research. If you need one-on-one help with making this big decision, work with a reputable financial advisor.
I highly recommend finding someone who works on a fee-only basis, not on a commission. A fee-only financial advisor is most likely to keep your best interests at heart. Connect with someone who will help you create a workable strategy for your situation that is aligned with your values and priorities. WorthyNest®, my fee-only advisory firm, offers custom financial guidance to parents with packages starting at $300 monthly. Schedule a free, quick call if you’re interested in discussing this one-on-one service.Save at least 20% of the home’s purchase price for a down payment.
If you are a first-time homebuyer, I’d strongly urge you to take my advice on this. Otherwise, you may have to take out a secondary loan at a higher interest rate or pay Private Mortgage Insurance, also known as PMI.
What if the value of your home declines after the initial purchase, as happened to me in 2005 near the peak of the real estate market? I wasn’t a financial advisor then and had only saved 10% for the down payment.
My first home was one of the biggest financial mistakes of my life – at least a $15,000 loss on a $150,000 starter home when you factor in closing costs, realtor commissions, and renovations. That was a bitter pill to swallow. Yet, I learned valuable lessons.
If you keep the above strategies in mind, mortgage debt can actually be GOOD.
In fact, my husband and I had the option of taking our Missouri home sale proceeds in late 2019 and providing even more than a 20% downpayment on our new home in Florida.
However, with the mortgage rates so compelling at the time, we kept the extra cash and invested it in other long-term goals. You can exercise the same judgment when purchasing a new home.
Now let’s talk briefly about the other type of “good debt,” student loans.
In many cases, bachelor's degrees are required to get into any white-collar position. Some professions demand additional schooling. A newly-minted doctor or lawyer could easily have over $200,000 in student loan debt.
Is your child entering college soon?
If so, have a candid conversation with him or her about constructing a plan to pay off the debt. Think about the chosen career field, average annual earnings, and the time it takes to secure a position.
Encourage him or her to apply for scholarships. Getting general education credits (or even an associate degree) at a community college and then transferring to a four-year institution can also be a viable option to save money.
Is your child considering a field where supply outweighs demand?
Some advanced degrees no longer carry as much weight. I know a handful of law school graduates who could not find reasonable employment within a year of graduation, let alone a six-figure salary with a top-tier firm.
Make sure your child knows the risks of going into a highly saturated field. Encourage them to at least take a look at the ONet Online list of occupations that are projected to grow over the next ten years. Ultimately, your child will be the one making their career decision. The best thing you can do is present them with information that can help them on their path.
Not-So-Good Debt: Credit Cards and Autos
Now we’ll get into the more touchy side of the debt conversation.
Debt isn’t always good. It can be crippling to people who don't responsibly manage their finances. This is especially true when it comes to credit card debt.
MoneyGeek’s data analysis of recent government surveys had a few interesting findings:
People 35 and younger have lower average credit card debt (around $3,700) than older groups. For comparison, the average credit card debt of adults 75 and older is $8,100.
Adults in the highest age group, though having the greatest average credit card debt, were carrying less debt overall (only about 28% of individuals had debt).
Nearly half (~48%) of individuals in the 35 and younger group are carrying debt.
If you are a Millennial or a Gen Z, you are more likely than any other age group to be carrying debt.
The truth about credit card companies is that they prey on individuals who make the minimum payment. This may sound harsh but only buy on credit if you can pay off the balance in full each month.
If you spend more than you earn and need help with cash flow management, I encourage you to read the article on how to approach budgeting as well as my related articles on the envelope and detailed budgets.
Yes, credit cards can rack up serious debt, but they aren’t the only type of “not-so-good” debt. Let’s talk about car loans.
As you may have noticed in recent years, vehicle sales are at an all-time high. Buying a new car is expensive. And if you are overly concerned with what friends and neighbors are driving, you may be tempted to buy a new car every few years.
This is a dangerous proposition.
The desire to “Keep Up with the Joneses” really impacts your ability to build long-term wealth. When is it enough? After you have a luxury car? Two of them?
A car, if you remember from earlier, is a depreciating asset. That means it loses its value quickly.
If you purchase a vehicle for $40,000, it may only be worth $30,000 a year later. Not only are you making monthly payments, but you’re also going to get far less money when you sell it.
Additionally, there is no tax deduction for personal vehicle financing (business purchases are a different story). So you don’t get any financial breaks when buying a new car.
The solution? Hold on to a new car for at least 7 years.
Save up for the next car when you don’t have any more payments on your current vehicle. Or, get ahead of it and buy a used car with more mileage. You may not be able to keep it as long, but you will have negotiated a much lower price.
When you feel burdened by debt, there are steps you can take to clear negative items from your credit report. Money.com provides an excellent, in-depth guide on the factors that influence your credit score and steps you can take to boost your credit score.
Pay Down Debt or Save?
Alright. You see how some debt is healthy. How do you know when to pay down debt rather than save more for retirement? Here are a few considerations when it comes to investment versus debt reduction strategies:
1. BUILD AN EMERGENCY FUND.
Set aside enough cash in a money market account for true emergencies. If “emergency” evokes too many negative emotions, reframe it as an opportunity fund instead. This may be an opportunity to start a side business, travel more, or accomplish another goal.
2. GET THE EMPLOYER MATCH.
Ensure you’re contributing enough to your employer’s retirement plan to take full advantage of the match. It’s a no-brainer. Unfortunately, several employers reduced or took away the company match in 2020 because of the pandemic. If your family is still in a strong enough financial position to contribute to your 401(k) plan at work, consider maintaining your normal retirement contribution. This means you do not have to remember to reinstate it when your employer resumes the 401(k) match.
3. WEIGH THE INVESTMENT RATE OF RETURN VERSUS THE INTEREST RATE ON DEBT.
This assumes you’ve already built an emergency fund and are taking advantage of your employer’s match. Let’s say you have a credit card balance of $10,000 on which you pay nondeductible interest of 15%. By getting rid of those interest payments, you’re effectively getting a 15% return on your money! Which sounds better… paying off this credit card or earning 7% in an investment account? Eliminating high-interest debt is the bigger priority.
4. CONSIDER A HYBRID APPROACH BETWEEN EMOTION AND LOGIC.
When I work with clients, I always try to honor their particular ways of making decisions while also helping them balance logic and emotion.
If you’re an intensely focused person who values logic over emotion, making the best financial decision (from the standpoint of pure numbers) gives you satisfaction. Emotion may not come into the equation. You are comfortable “going without,” and you focus all your energy on paying down “bad” debt.
But this isn’t the only way to make a decision.
For others, financial decisions function differently. What makes the most financial sense may not “feel” good. Attending to a single goal while other goals take the back burner may become a cause for anxiety and regret.
You have many intentions – paying down student loan debt, saving for retirement, and funding your child’s education. And putting all financial resources toward only one of these goals at a time doesn’t emotionally make sense to you. For this type of client, I usually recommend allocating a small amount of money towards each goal.
Some clients who have mastered their day-to-day finances ask me, “Should I prepay my mortgage?” It’s a good question, and I don’t always have a definitive answer.
First, we focus on financial specifics like the mortgage interest rate, loan term, and income tax bracket. I also consider the client’s timeline for investing and risk tolerance. Thus, it’s easy to tell them which decision is better financially.
Yet, we can’t ignore the emotional aspect.
Why does the client want to prepay the mortgage? Is it to fulfill a lifelong dream to be debt-free by age 50? Travel the world five years from now? What is the underlying ambition?
When I work with clients, we try to balance the logical and emotional aspects of financial decisions in order to create a game plan that is actually workable for them.
All that said, the bottom line is this:
Debt, when used properly, can be a great tool to achieve your financial goals.
What is most needed is to learn how to manage debt better.
Want to bust the big family finance myths that are keeping you trapped? Download this Starter Guide.