Debt is not evil. There I said it. In and of itself, debt is just a tool that can be used to destroy or build up your financial future.
This week I was walking my dog on a humid afternoon, and listening to Jen Sincero’s You are a Badass at Making Money. I love this book, and at one point in the book she (sarcastically) calls debt the big bad wolf. I laughed out loud. On the street. My neighbors think I’m weird.
We in the personal finance world preach that debt is a terrible, awful, no good, very bad thing. But the truth is, we use it to do terrible things because we don’t use it smart, and we don’t use it properly.
The commercialized, socialized world we live in make it so easy to get access to a credit card, get a mortgage on a house with a payment that’s going to break us, get no payments for 60 days on new furniture, or my personal favorite, finance the purchase of new rims for your car.
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So how do we know whether we’re taking debt for the right reasons? Here are 3 key ways to know if you’re going into debt for the wrong reasons:
You’re buying things you don’t need to survive
When you’re buying anything you have two options. Save up the cash and buy it outright, or use some sort of financing to make the purchase.
I’m not talking about the credit card that you’re paying off every month just to get points. I’m talking about the credit card balance you’re carrying, or the new loan you took out for the new model of your car.
If you are buying physical goods where you will be making payments for stretches of time, I challenge you to ask yourself: Do I really need this?
The term for this type of debt is Consumer Debt. You literally just bought stuff you don’t need and agreed to pay more for it via some sort of interest, or fees.
Yes, I consider a car consumer debt. Just like any other consumer item, you could sell it, but unless it’s some type of antique or special car, it’s probably not going to be worth nearly the price tag you agreed to. AND you’re paying more than that price tag via interest.
Recently Michele at Making Sense of Cents wrote about why you should never finance furniture or electronics. What she really drove home, and I’m over here cheering her on, is that people don’t do the math on how much all that extra interest, or the monthly payments are really going to make XYZ item cost.
Whether you’re a mall brat, die hard late night infomercial fan, or new car enthusiast, remind yourself, it costs you way less if you can save up and pay in cash.
You’re buying assets that will hold you hostage
Feel free to interpret hostage loosely here.
Even if you don’t agree with me that financing cars or boats is really consumer debt, we can all agree that the long term monthly payment structures can really cramp a lifestyle. And the one I see the most is the house.
Here in Texas, land is cheap. But big, fancy houses are not. If you strap yourself in for 30 years of a hefty chunk of change, you had better be darn sure that you’ve set yourself up to live with that payment.
It’s called being house poor, but you can be car poor, boat poor, or whatever other crazy long term financing item you can buy poor. What I’m saying is, you need to be comfortable with both your day-to-day expenses and your monthly payments.
There is a rule I try to follow in my personal long term debt: Keep car payments, house payments, and any other traditionally financed items close to 10% of my after-tax income.
If I can’t make that true, then I need to either earn more money, or pay off one of the items.
I’m going to double down on the hostage theme. When it comes to houses, boats and cars, these payments can define and cramp your life geographically, too.
A mortgage on a house physically ties you to the land it is on. You better be sure that you want to live there long term, in exactly the state, city, and neighborhood that you’re buying.
Furthermore, your boat can only go in water that you can drive it to, and your car can’t fly either. Anchoring yourself to a boat or car payment may mean that you can’t afford to travel abroad.
You’re “Investing” in something without understanding the payback
The last major way that people can tell they’re in debt for the wrong reasons is that they’re ‘Investing” without considering the payback. There are two really popular ‘investments’ here: education, and business.
You can kill the payback in three main ways: spending too much, not accounting for the return, or not executing the plan.
Spending too much can kill any deal. It’s hard to have a positive return on investment if you’re overpaying in the first place. The problem is that in education and business both, the extra spending can creep up on you at a time when you’ve sunk a bunch of debt into the plan anyway. You may take a “victory lap” in college because you didn’t understand prerequisites, or you may have to re-up the franchisee license, but either way, those will limit your payback.
Not accounting for the returns is really about evaluating whether to take on the debt up front. When you’re wide eyed and bushy tailed at the new opportunity, you may overlook the fact that you’re spending $700 per month to get yourself $300 per month. On paper it may obviously be a bad deal, but there are too many stories of people who go into massive debt with minimal returns on the back end.
The last one is close to my heart: execution. When you go to college or start a business, you always have a plan. But when reality sets in, it’s a little harder and scarier to execute than you initially thought. Maybe you didn’t think you’d have to go on so many job interviews. Maybe you didn’t know as much about internet marketing as you thought you did. Either way, this one is inexcusable. If you’re taking on the debt, have the courage to finish the plan.
Debt is not evil, but we need to use it smart.
Debt is just a tool. More specifically like a Swiss Army knife. There are all different kinds of debt, but choosing the right one will get the job done best. And sometimes there’s an even better tool for the job, cash.
It can build really awesome things like your dream house or a business that lets you work and travel. But it can also hold you down if you’re not careful where you use it.
So I told you a few warning signs that you’re getting into debt for the wrong reasons, but I feel like I should tell you a few signs that you’re using it correctly too:
You literally need the item to survive: You understand the terms and conditions of the debt, there is no better debt alternative available to you, and you absolutely must purchase the item today.
You are working the system: You understand the terms and conditions of the debt, and it won’t cost you more money than paying in cash. (only do this if you’re good at it)
You are avoiding a worse financial situation: You understand the terms and conditions of the debt, there is no better debt alternative available to you, and by taking on the debt you will avoid a worse financial situation. (ex: you cannot walk or take public transportation to work, so you take a loan on a car to avoid losing your job)
You are Investing with a Plan: You have a plan built with each step laid out for the debt, and the payback period.
I know there are ways I’m missing here, so help me out with more acceptable reasons for debt in the comments!