Are the heroes and villains of debt really what they seem?
When I first started to learn about personal finance, I consistently heard one truth — there’s good debt, and bad debt. A mortgage and student loans were good debt. Anything else — credit cards, personal loans, overdrafts — was bad debt.
And it made sense. Good debt was used to fund sensible, necessary things, while bad debt was used to support an irresponsible lifestyle and living beyond your means.
But as I’ve learnt more and begun to utilize these debt tools myself, I’ve discovered not only is this untrue, but holding that belief could potentially be dangerous.
Good Debt Gone Bad
The underlying logic of what makes debt “good” makes sense. You need somewhere to live, and over time a house will increase in value. Renting is paying off someone else’s mortgage, so why not pay off your own?
Similarly, a student loan is an investment in your future, and a good education will result in a higher paying job. Both are offered with comparatively low interest rates, making them seem feasible and safe.
And while these factors still remain fundamentally true, changes in cost and affordability calculations mean this safe bet has become more of a gamble.
House prices have increased rapidly in relation to income. In the mid 80s and 90s the house price to income ratio was around 3. Compare that to today where it’s 4.5; and a far cry from the rule of thumb of 2.6 historically used to determine affordability.
While there are legal limitations on how much you can borrow from a lender, the calculation is based on the monthly repayment amount rather than the total property value. With interest rates being their lowest in 50 years, it means we’re buying more expensive houses than we can really afford.
We need to challenge the way we think about how lenders determine what we can borrow. Referring to it as an affordability calculation implies our best interests are being taken into account. In reality, the lender is simply doing a risk assessment on the likelihood that we’ll be able to make repayments.
Lenders can spread this risk over thousands of borrowers, but you’re not a statistic. Salaries change, life happens, and you could easily find yourself in a difficult situation with a large mortgage on your shoulders. Affordability must be based on our own circumstances and our own risk tolerance, not that of a bank.
College tuition fees and lending have followed a similar trajectory. Adjusted for inflation, fees have increased by more than 250% since the late 70s. But wages haven’t kept up, with college tuition increasing nearly eight times faster than wages.
So while a good education may result in a higher income, it’s all relative. Unlike home loans, there’s no formula behind it to connect the loan size offered and income potential. The investment made in education might not get the return you expect (or need), which is an issue if it’s a large part of the reason for going.
People are taking on a huge financial burden with the hope that it will pay off in the long run. And those student loans are with you through thick and thin, including bankruptcy where they will only be discharged in exceptional circumstances.
Education is essential for personal growth and the success of a society, but a more strategic and measured approach needs to be taken when taking on debt. We can no longer treat the investment as a sure thing, and continue thinking all student loan debt is good.
Credit Where Credit Is Due
An easy target for any personal finance advice is credit card debt. And it’s understandable as we hit an all-time high amount of $930 billion in credit card debt in April this year.
Despite nearly half of all households having credit card debt, there’s still a judgmental view on those who have it. There’s a perception that those who use credit cards are doing so recklessly to fund extravagant purchases. But the reality is that people are using credit cards to make ends meet, pay for car repairs and to cover medical bills.
I want to make it clear that I am in no way pro-credit card debt. With an eye-watering average interest rate of 17.73% it’s an expensive way to live. But when 58% of Americans have less than $1,000 in savings, and nearly half expect to live paycheck to paycheck this year, it’s understandable that it’s seen as the only option.
Credit cards should be seen as a tool, one used to provide short term coverage of expenses in times of need when the cash just simply isn’t available.
Stuck In The Middle With You
Falling into the middle ground of debt are car loans. Cars are a necessary means of transportation for many Americans, including commuting to work so they can earn an income. However from a financial perspective, cars are depreciating assets which are expensive to buy and expensive to maintain.
Often the rational argument of the necessity of a car is used to justify some very irrational behavior, spending an inordinate amount on a car. The average loan for a new car comes in at around $32,000, and for a used car it’s $20,137. With the average salary being just under $50,000, we’re a nation that’s over leveraged on our cars.
To make car loans more attainable, monthly costs are made lower by extending the term of the loan, up to 84 months (that’s 7 years!). This causes the same problems as mortgage affordability calculations, focusing on the monthly payments rather than the total loan cost.
Best case scenario, a car would be worth about 43% of its original value after this 7 year period due to depreciation, and that’s before we’ve even taken into account the interest, fees and other costs associated with owning a car. It’s easy to see that a sensible purchase made with the best intentions can easily become a huge financial burden.
Debt is a necessary part of life for the majority of Americans, and it’s not as simple as being good or bad.
The fallacy that mortgage debt and student loans are automatically “good” will continue to lead people to take on more than they can afford. And the disdain held for credit card debt brings on unnecessary shame and embarrassment to those who are put in the position of having no other choice.
A good use of debt is something that helps you be in a better place in both the short and long term; whether that’s a roof over our head, a stepping stone to a career through education or simply putting food on the table in hard times.
We must find the balance between what we want, and what we can truly afford, and use debt wisely to make that happen.