Dealing with That Four Letter Word: DEBT

While some personal finance gurus are completely averse to debt and advocate that individuals undertake herculean efforts to become debt-free, we do not consider all debt to be bad.  A manageable mortgage, for instance, can have significant tax benefits if you itemize deductions and can also have investment benefits if you earn more by investing the available capital than you pay in interest on the borrowed funds.  In addition, with car loans and home equity loans currently offering such low rates, many clients have opted to borrow a portion of the funds needed for new cars or home renovations, and, provided the payments are affordable, one’s income is steady, and the term of the loan is reasonably short (car loan should be five years or less), we have no objections to this type of debt either. 

Bad Debt.  However, credit card and other high-interest debt, which is often used not just for lump sum purchases but to subsidize one’s standard of living, can be very detrimental to one’s financial well-being.  First, using debt to pay for a higher standard of living than one’s income will support is a trap from which it will generally take significant effort and discipline to escape.  For some people, a raise, a higher paying job, or a second income might make this problem go away, or they may have other assets or equity in their home that can be used to rid their balance sheet of the bad debt.  However, for most people, the answer is simply tightening their belts and lowering personal expenses until they reach a sustainable level.  Furthermore, while you remain in the trap, you unfortunately will be subject to the ugly side of compounding.  As we discussed in a prior post, compounding can be your friend when you are saving and investing money (accumulating investment gains on investment gains over time), but it is your enemy when you are in debt (accumulating interest owed on interest owed over time).

Escape Plan.  If you find yourself in this trap, you may be reading this thinking, “Yes, I already know this is a bad spot financially, but how do I get out?”  In his book, Financial Peace Revisited, financial author Dave Ramsey offers a couple of helpful suggestions on how to do this.  First, he insists that you must get angry about debt.  Unless you feel sufficiently frustrated at the amount of interest you are paying, the stress it is causing, or other negative consequences of high-interest debt, it will be difficult to muster the determination and discipline needed to lower expenses and increase monthly payment amounts to rid yourself of the debt.  Second, he recommends the debt snowball approach.  Whereas a strictly technical view of how to pay off debt might advocate starting with the highest interest rate debt and proceeding down the line to lower interest debts once the first is paid off, Ramsey promotes a different strategy, based on his observations of human behavior.  The debt snowball approach involves aggressively paying down the smallest debt (in terms of dollar amount) first, while making minimum payments on all other debts.  Then, once the small debt is completely paid off, you add the full amount of that first payment to the payment for the next smallest debt until that too is eliminated, and so on.

The key benefit of the debt snowball approach is that each paid off debt provides additional encouragement and motivation to keep working hard toward eliminating all of your bad debt and enjoying a more stable financial position.  Once you eliminate the debt (and assuming you have a sufficient emergency fund and retirement savings plan), you can start saving those monthly payments to a taxable investment account, so that you are ready for any lump sum or unexpected expenses that arise in the future and can permanently stay out of the bad debt trap.  As we’ve seen with many of our clients, it isn’t what you make, but rather what you spend, that determines your financial success.  Bad debt is a sign that spending is in excess of what is reasonable given your income level.