Debt – Tips to Avoid Trouble

Most of us are taught to avoid debt, and for good reason, as it can lead to financial stress or even bankruptcy.  Although the use of debt may be frowned upon and carries significant risks, we can’t seem to stop ourselves from acquiring goods and services on credit.  Since 2004 our use of debt is up over 60% – reaching $13.29 trillion dollars!

In the history of the United States, it has never been easier to “consume” using credit versus cash.  And, despite the risks, many American’s are all too willing to head down this path.  The statistics confirm that we are, in fact, often living beyond our means.  According to federal data, about 12.8 million of us filed for bankruptcy in federal courts between October 1, 2005 and September 30, 2017 (or, about 1 million per year on average).  So, how do we avoid becoming one of those statistics?   Here are some tips based on my experience.

House Debt –  Most of us purchase a home using debt (aka a “mortgage”).  Mortgages are common because houses are expensive and very few people have the money to pay for a house with cash.  It’s important to remember that there are different types of mortgages and choosing wisely can save you money.  In general, I recommend “fixed-rate” mortgages in which the interest rate and payment amount are static for the term of the loan.  I find that consumers are better able to budget with these types of mortgages versus “floating rate” loans that can escalate in the early years and create unexpected burdens.  Also, when buying a home, it’s important to maintain a reasonable loan-size to house-value ratio.  Regardless of what your lender will allow, I would recommend that you pay at least 20% of the home value in cash.  So, for example, on a $300,000 house you would contribute $60,000 in cash and obtain a mortgage loan of $240,000 (i.e., a loan-to-value ratio of 80%).  There are three main benefits to this approach, (1) it generally avoids you having to pay for “mortgage insurance,” (2) it provides a buffer such that a drop in home value doesn’t leave you with an asset that is worth less than the loan on the asset and (3) it allows some buffer in the event that you need to obtain a “home-equity” loan.  Home-equity loans are one of the cheapest forms of debt but can only be obtained if you have “equity” in your house meaning that the house is worth more than the loan that it secures.

Car Debt – It’s often been said that new cars lose 20% of their value when you drive them off the lot.  For this reason, purchasing used cars may be a great way to lower costs and avoid debt.  Assuming a car loan can’t be avoided, there are a few strategies to consider.  Often a new car loan from the manufacturer can be a smart decision because they frequently offer special loan rates (e.g., as low as 0%).  However, these rates are generally only available to the lowest risk customers.  If a low-rate loan from the manufacturer is not an option, it generally pays to shop around.  Rates for higher-risk customers will vary dramatically by lender so one would benefit from checking multiple offers before deciding on a lender.

Credit Card/Other Debt – In general, I would advise people to avoid credit cards in favor of debit cards or to simply pay them off each month.  Credits cards, along with other forms of short-term financing (e.g., furniture leases, “payday” loans, etc.), generally carry extremely high interest rates and are a quick way to find yourself with a cash-flow problem.  If you think about it, credit cards are the prototypical example of living beyond our means.  Excluding emergency situations, why would we ever think it makes sense to spend money that we do not have?  If you do wind up with substantial debt at higher interest rates, you will want to look for opportunities to “re-finance” the debt (i.e., replace the debt with lower-cost debt by paying it off with a traditional bank loan, home-equity loan or even a loan from an on-line lending marketplace such as Prosper).

Student Loan Debt – As you may have observed from the Federal Reserve chart, one of the fastest growing loan segments is student debt.  In fact, it is now second in size to home mortgages.  It is an unfortunate situation that many individuals cannot obtain an education without getting into debt.  This situation is largely driven by the escalating cost of higher-education that has grown at a much faster pace than income and savings.  I would certainly caution individuals from taking on too much college debt.  College debt is generally not able to be “discharged” (i.e., removed) in bankruptcy so it is a particularly scary form of debt.  As a general rule, I recommend state and community college options versus higher-priced private-school tuition as I generally find them to be a better value with lower financial risk.  Moreover, students should actively seek “merit aid,” “financial aid” and other grants before turning to debt as these options are far easier to obtain today than in the past.

In summary, I think it’s great to work toward a goal of being debt free.  Many of my clients who are debt free mention the great weight that is lifted once this status is achieved.  It’s generally a long road to get there but can certainly be life-altering.  Good luck to you in achieving your own financial goals!