October 13, 2021 – The determination of what to do with money is not intuitive. As a child, your first connection to money was probably the result of a holiday or birthday gift. Maybe, it was your first exposure to bribery from an adult who needed alone time. Your parents or well-wishing relatives may have introduced you to your first financial product- the piggy bank. In time, and before iTunes and Amazon, the financially savvy youth would ask, “What should I do with my money?” The classic answer to this innocent question, and the one given to me by my parents, was “Save some, spend some and give some sway.” Hence the truism, “All I really need to know, I learned in kindergarten.”
Interestingly, while the topics of spending, saving, and charity are top of mind on our financial planning checklist, the borrowing of money, aka debt, consumes a disproportionate amount of our client’s intellectual and emotional capital as well as our time. I surmise that the ins and outs of borrowing money never was a perfect teaching moment in our youth. If it did happen, it was probably behind the scenes (parents or siblings raiding your mowing or babysitting money) or tied to clear emotional times, either good ones (the mortgage burning party) (Note – Not sure this is a memory for the younger person) or not-so-good ones (coming up short on the payment due).
Fast forward to the adult you. Your more recent experience with debt might have been your surprise that student debt must be paid regardless of how much you make or even if you have a job. Or maybe you succumbed to the constant correspondence you received from financial institutions to obtain a credit card, or the 10% one-time discount offered when buying with store credit. And yes, there is a minimum payment due, which, if made, leaves a 20-25% interest charge on the remaining balance or, worse, a minuscule credit score if the minimum payment is missed once or twice!
As Financial Life Guides, we can understand and empathize with why borrowing is a complicated topic for our clients. It requires a fair amount of education on debt structure (terms, rates, fixed, adjustable, maturity, down-payment, unsecured, collateral, etc.) and an even more difficult discussion when devising a debt reduction/consolidation plan.
For this article, we are hoping you can come away with two insights:
- Debt is not inherently bad to have.
- Debt results from a decision that you make.
GOOD DEBT VS BAD DEBT
In an ideal world, the perfect amount of debt would be no debt. However, no debt is unrealistic for many who want to go to college, own a home, start a small business, or need a car for work.. In these types of situations, debt might be not only necessary, but also an appropriate way to build wealth. In each example, you borrow money to invest in something that will provide you with a higher return. Education will lead to higher potential earnings. Your home will provide the shelter you need with the potential to appreciate. Transportation is often a requirement for specific occupations. And starting your dream business will provide multiple returns and a career that you enjoy. These are examples where borrowing money allows you to become economically ahead of the game. It allows you to pursue a course of action much more significant than you could accomplish without financial help. For this reason, business debt is often described as “leverage.” If you are a good student, buy a home in a great location, progress at your job, and start that “killer” business, you will be leveraging other people’s money to grow your wealth! This is considered Good Debt. While lenders will still require an understanding of your ability to pay interest and eventually pay back the debt, they seek these types of loans. They are willing to charge reasonable interest rates because your economic gain reduces their risk of lending money.
Bad Debt occurs when you borrow to purchase a depreciating asset, meaning something that won’t go up in value or generate any income. Clothing, food, and other consumables are necessary purchases, but borrowing to buy them with high-interest debt doesn’t provide any leverage to increase your wealth. Using a credit card for convenience is OK, but you should be able to pay your entire balance each month.
BEING IN DEBT IS A CONSCIOUS DECISION
We have established that borrowing money, in certain situations, can be instrumental in creating wealth. It is available in your “financial toolbox” at times when opportunities appear, and your cash flow allows you to take advantage of the situation. Getting into debt should be the result of thoughtful consideration and provide excitement for the potential it provides. Interestingly, when good debt successfully creates wealth, you face another decision- should I pay off my debt? Should I keep the mortgage on my home? Should I pay it off sooner?
The US is the only country in the world where banks will lend you money for up to 30 years, at a fixed rate of interest, allowing you to renegotiate if mortgage rates decline, all while barring themselves from renegotiating if mortgage rates increase. With mortgage rates at historical lows, would it be wise to utilize money that otherwise could be leveraged for a higher return? Economically, the answer is no. However, there is a certain satisfaction to not being in debt and ending monthly payments, which is priceless! After decades of advising, even pleading with clients to not pay off mortgages or buy vacation homes with cash, I finally arrived at the proper analysis. I call it the “pillow theory. If worrying about having a mortgage prevents a good night’s sleep, it becomes a bad debt that should be eliminated as soon as possible. The appropriateness of debt is unique to everyone. Our financial decision analysis is well suited for modeling various scenarios and their impact on your financial plan. Unfortunately, the answer might be a warm glass of milk before bedtime.