Bad Debt
Is all debt bad? As a person who loves to talk about reducing debt, you might think that my answer to this question would be YES!! But, that is not what I believe.
Debt in and of itself is not bad. Too much debt is bad.
Debt is simply a tool to allow you to take advantage of a purchase prior to being able to pay for it in full. Debt can be a great tool that you can leverage to your advantage.
The problem with debt is that it is so easy to incur too much of it. Most people are not disciplined.
Ways That I Use Debt:
1. Buying A House Using A Mortgage
I think that most people should use debt to buy a house. Very few people can save enough money to pay cash for a home. As long as you buy a house that you can afford to pay the mortgage I would not characterize this as bad debt.
2. Taking Out Student Loan Debt To Pay For College
As you might have read in my last article on Student Loan Debt, I used student loans to finance both my undergraduate degree and my law school degree. While I believe I financed WAY TOO MUCH, it certainly was a road to a higher salary for me.
Student loans are often a necessity today. And, they can be a great tool to gain the skills for the job you want to do. But, I think that people are paying way too much for their education. I will be discussing this a lot more on The Debt Hawk.
3. Using An Auto Loan To Purchase A Car
I would like to be able to say that I have saved up enough money to purchase my car, but I have not. I don't like to finance car purchases, but at this time, I do not have enough savings to pay cash.
4. Credit Cards For Cash Back Rewards
This is a very difficult one. I think that credit cards are very dangerous tools. They are the nail guns and miter saws of debt tools. But, if you can pay off your credit cards in full every month, then I think you can use them to your advantage for cash back rewards and travel reward points.
When is debt bad?
In simplest terms, debt is bad if you can't afford to pay off your debts while meeting adequate savings goals. Most people only determine whether their budget has room to pay the payments on the new debt. But, this is too liberal.
The real question you need to answer is can you afford to take on this debt and still afford to meet your savings goals. When you can't do this, you are mortgaging your future.
So, all debt is not bad. It is merely a tool that can be used responsibly or irresponsibly.
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I think debt almost always has a down side, even when it’s used for a good purpose like buying a house. When you have debt to finance one thing, you’re almost always going to be sacrificing another thing – freedom, opportunity cost to invest, etc.
Cars go down in value. Sometimes rapidly. So using debt to buy a car is a very bad idea. You will end up with a $8,000 car and a $12,000 loan, and be unable to sell the car if you need to.
Also, if you have $10,000 in cash, you can shop around and get a very good deal. You can buy a nice used car privately even. If you’re “trapped” into needing financing to buy a car, dealers can sell you on a more expensive car. They can pile on various fees and you won’t feel it as much because you’re focused on the monthly payment.
There is a reason car financing companies (GMAC, Toyota Finance, etc.) are the most profitable arms of car companies. Notice that GM went bankrupt. GMAC did not.
Using credit cards for points is another trap. It’s like the mouse who says a mousetrap is a good source of cheese. Yes, you can try to get something for nothing. You can sometimes snatch the cheese from the trap and not get caught. You can go a few months and “win” at this game of getting points and not paying any interest or fees.
But once every few months something will be tripped up. You’ll not receive the bill in the mail and not pay on time. The payment doesn’t get applied in a timely fashion. You run into a cash flow problem and, no surprise, you decide to only pay the minimum payment this time. You lose your job. An unexpected expense means you can’t pay the full amount as you intended. Any number of things can happen. It’s a trap, waiting to spring.
There’s no such thing as a free lunch. Most people end up paying some fees and interest even if they don’t intend to.
A house and an education I can agree with going into a small amount of debt for. There’s no point borrowing for a history degree or something that doesn’t lead directly to a job however.
It’s fascinating that we have a psychological need to always place debt into one of two categories- Good or Bad. Why can’t it be both, or neither at the same time. Debt is a tool, and if YOU don’t use debt the right way- then you become the “tool”…so to speak!
It would be easier to designate a PERSON as either good or bad at utilizing debt. Then our actions, or lack thereof in some cases, determine whether debt is good or bad.
Your choices determine how you use or misuse debt.
It’s also interesting that many people don’t think of something like a car loan or a mortgage technically as debt. I had this conversation with a coworker earlier today. His debt was only on his credit cards, so really he means unsecured debt. I’m afraid I take the extreme here and can’t find much good in debt, it certainly hasn’t worked for me so far.
Debt is a tool. Much like a chain saw, it can be useful and safe when utilized correctly. However, in the wrong hands it can be dangerous.