Don’t Be Fooled by Debt
“Debt” is a scary word. For many Americans it’s practically taboo. And for good reason: in January, NerdWallet found that the total amount of debt owed by the average American household in 2020 was about $145,000.1 But while there is reason to be cautious, debt can still be an effective resource on one’s financial journey. In this article, we explore the various types of debt and how it can be reframed and seen as a tool instead of a threat.
Debt Can Be Scary
Having debt doesn’t feel comfortable. The looming threat of interest payments, penalties, and late fees leads many to worry that debt simply isn’t worth the risk. Even Dave Ramsey, one of the most well-known financial experts in the country, is of the opinion that there is no such thing as “good debt” and preaches that the best thing one can do is avoid debt at all costs (even going so far as to recommend buying your house in cash)2. However, as with most financial concepts, debt is not quite that simple. Tourniquet
In reality, debt is just another tool for your financial toolbox. And in your toolbox, you will have intimidating tools – like a circular saw. When used effectively, the circular saw is a brilliant and irreplaceable tool. But when used carelessly, a circular saw can cause great harm. Similarly, debt used irresponsibly can cost you an arm and a leg, while well-managed debt will open doors to previously inaccessible financial pathways.
The Makings of a “Good Debt”
Not all debt is bad debt. In reality, debt exists on a spectrum. On one end are debts that can advance your lifestyle or your financial wellbeing, such as student loans or mortgages. On the other end are costly or even predatory debts, such as payday loans or tax debt. It makes sense that payday loans and other predatory types of loans should be avoided at all costs. Exorbitant interest rates are the first sign that a debt is not worth the expense. Credit cards, however, are a little more nuanced. While many credit cards sport interest rates well over 20%, there is a way to use them without paying the price. As long as the balance is paid in full each month, a credit card can be an asset for one’s financial life by offering perks such as cash back rewards or airline miles. As Erin El Issa writes for NerdWallet, “While credit card debt can be bad, credit cards themselves are notinherently bad.”3
In most cases, low-interest debt can be considered a “good debt.” But when relied upon too heavily, even a good debt can cause harm: Carrie Schwab-Pomeranz of the Charles Schwab Foundation notes, “Good debt is bad debt when you’re drowning in it.” While student loans are often low-interest, occasionally forgivable, and generally useful to boost your earnings potential, high loan balances mean high monthly payments, sometimes requiring borrowers to rely on even more debt (such as credit cards) in order to make ends meet. The common rule of thumb for student loans, according to Schwab-Pomeranz, is not to take on more debt than you believe will be your first year’s salary.4
Furthermore, Janet Alvarez of CNBC writes that the dividing line between good and bad debt is the answer to the question, “Will this debt pay me back more than what I put in?” This is why student loans and mortgages are frequently considered the safest types of debts. Investing in your future self or building equity in an appreciating asset are two surefire ways to reap a return on your investment.5
Across credit cards, auto loans, student loans, mortgages, and more, it can be hard to know where to direct one’s cash flow. From a purely financial perspective, debt management can be simplified by looking at tradeoffs (or, in economic terms, the opportunity cost). Any debt management plan should start with making at least the minimum payment on each outstanding debt, so as to avoid additional penalties or late fees. Beyond that, according to Savannah Snider of US News & World Report, individuals should direct any spare cash flow toward the most expensive debt – that is, the bill with the highest interest rate.6When considering whether to pay down a debt, taking into consideration any alternatives is also valuable. For instance, if you have a mortgage that costs you 3% per year, it may make more financial sense to direct excess cash flow into retirement savings, where a prudent investment strategy can potentially yield greater than 3% per year over the life of the loan.
As with all financial decisions, however, strategizing around debt management requires more than just a logical approach. Money is a sensitive subject, and emotion is always at play. Many people set a goal to be debt-free by retirement or to pay off their mortgage ahead of schedule because, for them, the feeling of security from being debt-free is worth far more than the potential benefits of investing those dollars elsewhere. The best debt management plan is one that goes beyond the “dollars and cents” answer and incorporates one’s perceptions and attitudes around debt as well.
With all financial decisions, there are risks to be weighed and tradeoffs to be made. Managing debt is no different, and it adds the complex emotional dimension as well. While popular advisors and rules of thumb can provide a good starting point, we at Yeske Buie believe that the greatest benefit comes from having conversations with those who know you best. So if debt makes you anxious or you don’t know where to start, feel free to give us a call. We’re good people to think with.
- El Eissa, Erin. 2020 American Household Credit Card Debt Study. NerdWallet. January 12, 2021.
- Ramsey, Dave. What Are the Types of Debt? DaveRamsey.com. July 17, 2020.
- El Eissa, Erin. Why Is Credit Card Debt ‘Bad’ Debt? NerdWallet. September 17, 2014.
- Leonhardt, Megan. Here’s how much to borrow in student loans. CNBC. August 28. 2018.
- Alvarez, Janet. Good debt vs. bad debt: Why what you’ve been told is probably wrong. CNBC. July 20, 2020.
- Snider, Susannah. How to Kill Your Fear of Debt. U.S. News & World Report. February 12, 2019.
- Carter, Shawn. One financial fear scares millennials even more than death. CNBC. November 8. 2017.
- Pyles, Sean. Good Debt vs. Bad Debt: Know the Difference. NerdWallet. February 18, 2021.