In the world of personal finance, some people view debt as either good or bad. Others view it as a tool you can use to build wealth. I am of the mindset, however, that there is no such thing as good debt. And that tool can just as easily backfire in your face. For me, debt is just debt, and there isn’t anything good about it.
Debt is a Problem
Before diving into my thoughts and opinions about debt, I wanted to take a step back and look at the bigger picture. Owing someone else money, it seems, has become a part of everyday life. It’s normal to have debt. You’re supposed to have a car payment, student loans, or a credit card balance. Home ownership and the accompanying mortgage is a life requirement.
That’s just how things are supposed to be.
But debt is a problem. Let’s take a look at some statistics, shall we?
According to a recent NerdWallet study, the average debt among balance-carrying households were as follows:
- Credit cards: $15,654
- Mortgages: $173,995
- Auto loans: $27,669
- Student loans: $46,597
- Any type of debt: $131,431
In other words, for those households with credit card debt, the average balance was over $15k.
The Federal Reserve Bank of New York, in their quarterly report on household debt and credit, found that for the third quarter of 2017:
- Aggregate household debt increased by $116 billion in the third quarter, and has increased for 13 consecutive quarters
- Total household indebtedness was $12.96 trillion as of September 30, 2017
- Student loans grew by $13 billion and, in total, stand at $1.36 trillion
- Mortgage balances totaled $8.74 trillion
Some interesting tidbits about student loans from Debt.org:
- Student debt acquired every second: $2,858
- Average student debt 2017: $37,172
- 70% of college graduates leave school with student loan debt that averaged $38,000
And finally, for all those car lovers out there, Experian took a look at loans and leases in Q3 2017:
- Total open automotive loan balance: $1.12 trillion
- Average loan payments: new $502; lease $412; used $365
- 43.2% of new car loans have terms of 61-72 months; 30.5% have terms of 73-84 months
Good Debt vs. Bad Debt
There are a lot of definitions of good debt and bad debt. For the most part, good debt is that which can help you increase your net worth. Some examples include:
- Student loans: increases your earning potential
- Home mortgage: real estate tends to increase in value over time
- Small business loan: will you be the CEO of the next Amazon?
On the other hand, bad debt decreases in value and lowers your net worth. Some examples of bad debt:
- Credit card debt: instant gratification at the expense of double-digit interest rates
- Car loan: that new car depreciates the second you drive it off the lot
- Payday loans: probably worse than credit cards as you can see here
Debt as a Tool
Instead of viewing things as good debt versus bad, some might think of using debt as a tool to potentially increase the return on an investment. This strategy is known as leverage.
A classic example of leverage is real estate. For instance, let’s say a real estate investor purchases a $100,000 home by putting $10,000 down and financing the remaining $90,000 using a loan. To keep things simple, that same investor is able to immediately sell the home for $110,000. What’s their return on investment? 100% ($10k down payment, $10k profit after selling). On the contrary, if they had purchased the house in cash for $100k, their return would only be 10% ($10k in profit, $100k house purchase).
Another common example of leverage is investing extra money instead of using it to pay off low-interest debt, such as refinanced student loans. In this case, you are hoping for a return on investment that is greater than the interest rate on your debt.
My Issue with “Good Debt”
My main qualm with “good” debt is that it’s only good when times are good. When real estate and the stock market are doing well, leverage works as planned and your debt can appear good. But on the flip side, things can feel not-so-good if your property goes down in value or your return on investment isn’t as high as you thought it would be. Leverage can increase your return on investment, but it can magnify your losses as well.
Another thing that could come up is, you know, life. You could lose your job, have a hard time finding a job after college or graduate school, become ill, or have an unexpected expense or emergency come up. I know what you’re thinking: “SRGO, that’s what my emergency fund is for.” First of all, kudos to you for having an emergency fund. You’re way ahead of those who don’t have enough saved to cover a $1,000 emergency. I’m pretty certain, however, that your emergency fund will only cover minimum payments and won’t go toward purchasing investments. Your leverage is gone, and all that’s left is good old-fashioned debt.
And finally, you have to actually invest that extra money instead of spend it. While those with some financial knowledge will see that as a no-brainer, it’s easy to forget that most people may not be as financially astute. It’s human nature to be tempted by shiny new objects. We live in a consumerist society after all, and some people fall victim to spending that extra money.
Debt can be, for lack of a better word, necessary. Not everyone can self-finance an education or afford to pay for a home in cash. And while I do understand the reasoning behind calling certain debt “good” or viewing it as a tool, there are still risks that some people may overlook given these positive monikers.
For instance, that college (or graduate school) degree does not guarantee you a well-paying job. Life can happen. You can lose your job, emergencies can pop up, or health issues can arise. Investments can go down in value or you could end up spending that extra cash instead of investing it, effectively short-circuiting your attempt to leverage that “good” debt.
So where do I stand on debt? As I mentioned earlier, I’m not a fan of it. Maybe I’m a bit biased because I’ve carried debt (and still do… darn mortgage!) my entire adult life. I understand how much of a drag it can be in terms of saving money. But I get that personal finance is personal, and some people are comfortable with leveraging debt. That’s all well and good, just keep in mind that even “good” debt is not without risk.
As for me, I plan on becoming debt free as soon as I can. My student loans are gone, and all that’s left is our mortgage. I still have a few more years to go, but I’m looking forward to living a life without any payments.
Readers, what do you think? Do you see debt as good versus bad? As a financial tool? Let me know in the comments below!
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