As you know, a personal finance blog has to have at least one (hundred) article(s) on debt. I’ll start with dealing with what I consider the number one rule of debt: You should never have any of it. Period!
… except, of course, some debt that you might need – more about that later.
Why you should never have any debt
Debt comes in many shapes, forms and sizes. The most well-known types of personal debt are mortgages, credit card debt, auto loans and student loans. There are MANY more ways you can get yourself into a sticky situation by taking up other types of debt.
There are even more technical ways of defining loans by being either secured, unsecured, demand, subsidized, concessional etc., but my best advice is to never learn about this and just get rid of your debt instead.
As we all know, debt (or a loan) works by an entity (typically a bank) lending another entity (typically someone like you – or not you, of course, but some of your less intelligent friends) money. The debt is then paid back including interest. The ‘interest’ part of this spectacular invention is the reason you are digging your own financial grave.
Why should you always avoid debt? Let’s look at some numbers:
In 2016, the average American household had $134,643 in debt. For the households carrying credit card debt, the average American household had $16,748 in credit card debt, which cost them $1,300 a year in interest.
$1,300. For. Absolutely. Nothing. When was the last time you threw $1,300 out of the window? I thought so. And keep in mind, this is only for credit card debt – no mortgages, auto loans or student loans, only for the right to use plastic cards.
If we assume the same interest rate across all loans, the average American household pays $10,451 in interest per year. When was the last time you threw…? You get the point.
As if this wasn’t scary enough, credit card debt is on the rise for American consumers.
If you have debt like the average American household, you don’t only just have a debt problem. YOU ARE BEING CONSUMED BY A BIG BLACK HOLE EATING AWAY YOUR WHOLE EXISTENCE ONE QUARK AT A TIME WITH IMPENDING DOOM OF NUCLEAR PROPORTIONS WAITING JUST AHEAD!!
Being in debt means spending ahead of time. In essence, ‘future you’ are spending money to cover for the purchases made by ‘past you’ – and let’s be honest, ‘future you’ is probably not going to have more money to stomach those purchases. If ‘future you’ takes on even more debt to pay for interest on old debt, then you are truly in for a financial suicide.
An example of how bad credit card debt can be
Still don’t believe me? Let me give you a final example on how wrong things can go with “just” $10,000 in credit card debt (remember how much the average American household has?).
Let’s assume you have $10,000 in credit card debt at 20% interest rate. Every month, you pay back the minimum monthly payment on the credit card – let’s assume 3% of the outstanding balance. Assuming that you don’t take on more debt, here is how much you will pay back and how long time it will take:
In the first month, you pay back $10,000 x 3% = $300.
Out of this, interest makes up $10,000 x 20% interest rate ÷ 12 months = $166.7. More than 55% of what you pay back in the first month is interest only.
The remaining debt (the principal) after the first month is $10,000 – ($300 – $166.7) = $9.866,7.
This calculation is then repeated as long as there is still principal left. Before the debt is paid, you will have spent 19.6 years and $21,852 on paying back initial debt of $10,000. Two decades and more than double the loaned amount!
A good rule of thumb here is not to pay back the minimum monthly payment, but to increase that amount to the maximum possible – or even better yet, not have any debt at all.
Now that we have established that you shouldn’t have any debt, let’s look at some debt you actually can have.
Some debt you could have: Mortgage loans
Internet warriors, assemble! I know that some of you might kill me for saying this, but I do believe that home loans are some debt that you can have. I know it is a big debate with lots of feelings, data and opinions, so I will not go into details about this topic, but feel free to add your perspectives in the comments!
In some cities around the world, it is impossible to enter the real estate market for people with normal finances (i.e. no rich parents, no huge savings etc.) without taking on a loan, and in some cities it is simply also the best financial decision to take on a loan to buy real estate.
Before taking on a mortgage loan, I would always recommend to buy real estate with cash or to rent a house/apartment unless that is more expensive than the interest you will be paying.
I believe that mortgage/home loans can be acceptable due to the following two reasons:
- You need a place to live and want a decent standard of living in an area that is right for you – I mean, you can’t live in a portfolio of stocks with good returns – just make sure that the mortgage payments still are a small part of your take-home income
- Mortgage/home loans work as hedges towards inflation. A $200,000 home loan will remain a $200,000 home loan in 20 years from now where the wonders of inflation will have made that loan much smaller in real terms
That’s it – no other good reasons for you to take on debt.
I believe that houses should not be seen as investments, but rather a cost. The costs that come with a house include mortgage/bank payments, utilities, maintenance, insurance, taxes, selling costs, opportunity costs etc.
I know that houses historically have increased in value in the long-term, but that does not justify seeing future home purchases as investments. You might be lucky that your house appreciates in value, but the next house you buy will most likely have increased by a similar amount. You might also be unlucky and lose a lot of money. No one knows. Therefore, I have recently bought a house with the expectation of making exactly 0% return.
I view the interest payments on the mortgage loan as money out of the pocket that I will never get again (same as rent). I view the down payment on the principal as a “saving” (home equity) that will get a 0% return, but can be liquidated relatively quickly by selling the house at any point in time. I expect to do this when I retire to use it as part of my nest egg.
There are too many factors influencing which way home prices go to be able to say that anything goes up or down: urbanization rate, GDP per capita, home improvements, interest rates, taxes, politics, psychology, development in local home share of take-home income, wars, etc.
Summing up, I believe you should avoid all types of debt, although some debt in the form of mortgage loans might be alright for the right reasons. I couldn’t agree more with Mr. Money Moustache who says: “Debt is a huge flaming emergency!!“.
What are your views on debt and mortgage loans? Please let me know in the comments!