A very legitimate topic for today’s consumer is the topic of debt. Over the last 100 years, the American consumer has been increasingly accepting of debt. Is that a good thing? Is that a bad thing? What IS debt? How is it used? What does it do? I’ll attempt to tackle as much of this as I can in this article. In all likelihood it will be a two- or three-part series, as the subject of debt is both very important and very complicated.
Financial debt, by definition, is taking money from a source that has it, using it for a relatively immediate purpose, and repaying that source back at a later point. As you can see, that idea can take on an infinite number of uses. Commercial debt is used to finance business creation, growth, capital expenditure, cash flow shortages, among other things. Public debt exists for infrastructure improvement and maintenance, social programs, defense spending, budget shortages, etc…. Individual debt actually looks a lot like commercial debt in its uses, but for a more personalize approach. People use debt to buy cars, homes, college degrees, manage cash flow shortages, and other things.
Now that we have a basic idea of what debt is and how it’s used, is debt bad? Let’s focus for today on the concept of personal debt. Over the last few years, some celebrity financial gurus have become quite famous (and rich, incidentally) preaching on the pulpit of “All Debt is Bad”. Like most things in life, debt isn’t bad or good. It’s in the USE of debt that we find the difference between what’s useful and what’s potentially crippling.
While all household debt falls into the 2 basic types of either secured or unsecured, let’s explore a more functional approach. In our current financial system, mortgage debt belongs primarily in its own arena. Banks and the financial system have a completely separate infrastructure for mortgages, thus we will deal with it separately. Following mortgages are other types of secured debt (meaning it has real property that it’s loaned against), like auto, property, boat, or any other loan that can be secured by real collateral. After that we have unsecured debt such as student loans, medical bills, etc… Finally, we reach consumer debt. The most common type is the good ‘ole credit card.
The primary reason we use debt is to acquire a thing that we cannot pay for at this time, but we pledge a series of payments over time to pay for it. Generally we use banks or financial institutions as providers of the cash we need for the acquisition. The upside is that we get that thing NOW. The downside is actually twofold. First is that we have to pay interest, as banks are for-profit institutions that lend for a profit. Second is that we pledge part of our cash flow to pay off this debt. That requires that we have a steady stream of income to pay this from. Here is where we circle back to the use of debt and how it can either be a benefit or a burden to your household.
Let’s talk mortgage debt first. If you have good credit (that’s something we should discuss later on sometime), our financial system has a set of rules that makes mortgages the most advantageous debt a household can acquire. Borrowing on a mortgage oftentimes means getting a loan for less than the long-term rate of inflation. As long as your cash flow is comfortably above what can handle a mortgage payment, it’s mathematically prudent to carry a mortgage. Notice the statement above says “as long as your cash flow is comfortably above what can handle a mortgage payment”. Just because you get pre-approved for a certain amount, don’t think that’s the amount you need to spend or borrow for a home. If used properly, mortgage debt can be used to acquire an appreciating asset that costs less interest than the long-term rate of inflation. If used improperly, a mortgage can lead to bankruptcy, foreclosure and homelessness.
Next is general secured debt. Is this debt advantageous? It can be. 5 year car loans at 0% are basically using free money from manufacturers as long as you’re not paying a higher price for the car to get it. Also, vehicles are generally a depreciating asset. Don’t purchase a vehicle you don’t need just because it has cheap financing. Loans for investment properties can also be good if the property generates income sufficient to cover the financing. On the other hand there are some types that just don’t make a lot of sense. Debt for assets that either depreciate or don’t generate income is almost always a bad idea.
Last is unsecured debt. For the most part, unsecured debt is a bad idea. If you have the discipline to keep them paid off, some credit cards offer friendly terms and “points” systems that allow you to fly places, get a discount on your next vehicle or any other number of benefits. They can also offer some added security when travelling abroad or protection against identity theft. Just don’t run balances on them consistently. Their interest rates are mostly exorbitant and some carry annual fees that can make them extremely expensive to keep. Some unsecured debt is unavoidable, as medical emergencies can create a debt issue that was unintentional. The best offense against medical debt is a good defense. This is where reasonable health insurance and an emergency fund can really help. Student debt is a one-off here. As an advisor, I consider college degrees or professional certificates a quality of life choice and less about cash flow. A person can do some things to mitigate getting too much student debt, but sometimes it’s just unavoidable if they choose to engage in a certain profession.
Household debt in America is far from a black and white issue. Some types can be quite useful if used properly, while other types can ruin an adult’s financial future. Play by some basic rules and debt can be a tool, not a hinderance. Don’t work for your debt, make your debt work for you.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.