Let's talk about debt baby. Let's talk about you and me. Let's talk about all the good things and the bad things that may be. Let's talk about debt.
Do I have you humming the tune to a popular Salt-N-Pepa song circa 1990?
Gotta bring some joy on this beautiful April day! OK. Last month, we talked about building wealth in the context of better job satisfaction and earnings potential. Now, let’s switch gears and focus on debt.
True or False? Some debt can be good.
But there’s a catch: You should be responsible with debt and use it to acquire an appreciating asset (one that will increase in value over time). That takes discipline and focus.
Good Debt – Mortgages and Student Loans
Many people can’t afford to purchase a home outright, or entirely with cash. They rely on a mortgage to finance the home purchase. If you are a first-time homebuyer, I’d strongly urge you to save at least 20% of the home’s purchase price for a down-payment. Otherwise, you will have to take out a secondary loan or pay Private Mortgage Insurance, also known as PMI. What if the value of the value of your home declines after the initial purchase, as happened to me in 2005 near the peak of the real estate market? I wasn’t a financial advisor then and had only saved 10% for the down-payment. My first home was a big financial mistake – at least a $15,000 loss on a $150,000 starter home when you factor in closing costs, realtor commissions, and renovations. Yet, I learned valuable lessons.
Mortgage debt can be good. Now, my husband and I live in a home valued over $300,000 with mortgage debt under $180,000. Interest rates are still at historical lows, and we managed to snag a 3.5% rate for a fixed, 30-year mortgage. Added bonus: mortgage interest on your primary residence is tax-deductible.
The other “good debt” could be student loans. In many cases, bachelor degrees are required to get into any white-collar position. Some professions demand additional schooling. A newly-minted doctor or lawyer could easily have over $200,000 in student loan debt!
Is your child entering college soon? If so, have a candid conversation with him or her about constructing a plan to pay off the debt. Think about the chosen career field, average annual earnings, and time it takes to secure a position. Is your child entering a field where supply outweighs demand? Some advanced degrees no longer carry as much weight. I know a handful of law school graduates who could not find reasonable employment within a year of graduation, let alone a six-figure salary with a top-tier firm.
Bad Debt – Credit Cards and Autos
Debt isn’t always good. It can be crippling to people who doesn’t responsibly manage their finances. Credit card companies prey on individuals who make the minimum payment. This may sound harsh, but only buy on credit if you can pay off the balance in full each month. If you spend more than you earn and need help with cash flow management, refer to my earlier article on the Envelope Budget.
Credit cards aren’t the only type of debt. Vehicle sales are at an all-time high. If you are overly concerned with what friends and neighbors are driving, you may be tempted to buy a new car every few years.
This is a dangerous proposition.
The desire to “Keep Up with the Jones” really impacts your ability to build long-term wealth. When does it stop? After you have a luxury car? Two of them?
A car depreciates quickly. If you purchase it for $40,000, it may only be worth $30,000 a year later. Not only are you making monthly payments but you’re also going to get far less money when you sell it. Additionally, there is no tax deduction for personal vehicle financing (business purchases are a different story). The solution? Hold on to a car at least 7 years. Save up for the next car when you don’t have any more payments on your current vehicle.
Pay Down Debt or Save?
OK. You see how some debt is healthy. How do you know when to pay down debt versus save more for retirement?
Here are a few generalities:
1. Build an emergency fund.
If you don’t have three to six months of living expenses set aside in a money market account, start now. If “emergency” evokes too many negative emotions, reframe it as an opportunity fund instead. An opportunity to start a side business, travel more, or accomplish another goal.
2. Get the employer match.
Ensure you’re contributing enough to your employer’s retirement plan to take full advantage of the match. It’s a no-brainer.
3. Weigh the investment rate of return versus debt interest rate.
This assumes you’ve already built an emergency fund and are taking advantage of your employer’s match. Let’s say you have a credit card balance of $10,000 on which you pay nondeductible interest of 15%. By getting rid of those interest payments, you’re effectively getting a 15% return on your money! Which sounds better … paying off this credit card or earning 7% in an investment account? Eliminating high interest debt is a bigger priority.
4. Consider a hybrid approach.
If you’re an intensely focused person who values logic over emotion, making the best financial decision gives you satisfaction. Emotion may not come into the equation. You focus all energy on paying down “bad” debt.
For others, financial and emotional decisions function differently. What makes the most financial sense may not “feel” good. You have many intentions – paying down student loan debt, saving for retirement, and funding your child’s education. Putting all financial resources toward a single goal doesn’t emotionally make sense to you. Instead, allocate a small amount of money towards each goal.
Some clients who have mastered their day-to-day finances ask me, “Should I prepay my mortgage?” It’s a good question, and I don’t always have a definitive answer. First, we focus on financial specifics like the mortgage interest rate, loan term, and income tax bracket. I also consider the client’s timeline for investing and risk tolerance. Thus, it’s easy to tell them which decision is better financially.
Yet, we can’t ignore the emotional aspect. Why does the client want to prepay the mortgage? Is it to fulfill a lifelong dream to be debt-free by age 50? Travel the world five years from now? What is the underlying ambition?
The bottom line is this:
Debt, when used properly, can be a great tool to achieve your financial goals.
Deb Meyer, CPA, CFP®