Let’s talk about debt, baby. Let’s talk about you and me. Let’s talk about all the good things and the bad things that can be. Let’s talk about the debt.
Did I make you hum the tune of a popular Salt-N-Pepa song from around 1990?
I must bring some joy during the pandemic! OKAY. We talked about the importance of budgeting and cash flow analysis. Now, let’s focus on a related topic: debt.
True or false? Some debts can be good. Answer: True. But there is a catch. You should be responsible for the debt and use it to acquire an appreciating asset; in other words, an asset that will increase in value over time. It takes discipline and focus.
Good Debt: Mortgages and Student Loans
Most people cannot afford to buy a home directly or entirely with cash. They rely on a mortgage to finance the purchase of a home. If you are a first-time home buyer, I strongly encourage you to save at least 20% of the home purchase price for a down payment. Otherwise, you may need to take out a secondary loan at a higher interest rate or pay for private mortgage insurance, also known as PMI. What if the value of your home’s value drops after the initial purchase, as happened to me in 2005 near the peak of the real estate market? I wasn’t a financial advisor at the time and only saved 10% for the down payment. My first home was a big financial mistake – at least a loss of $ 15,000 on a $ 150,000 starter home when you factor in closing costs, realtor commissions, and renovations. Yet I have learned some valuable lessons.
Mortgage debt can be good. In fact, my husband and I recently had the opportunity to take the proceeds from the sale of our house in Missouri and provide even more of a 20% down payment on our new Florida home. However, with mortgage rates so attractive, we have kept the extra money and invested it in other long term goals. You can exercise the same judgment when buying a new home.
The other “good debt” could be student loans. In many cases, a bachelor’s degree is required to access any white collar position. Some occupations require additional education. A newly trained doctor or lawyer could easily have over $ 200,000 in student loan debt.
Is your child going to college soon? If so, have a frank discussion with them about developing a debt repayment plan. Think about your chosen career field, average annual earnings, and how long it takes to get a job. Make sure the student loans you take out make sense in this context, otherwise that good debt could turn into bad debt pretty quickly.
Is your child entering a field where supply exceeds demand? Some higher diplomas no longer have as much weight. I know a handful of law graduates who couldn’t find reasonable employment within a year of graduation, let alone a six-figure salary at a top law firm.
Not-so-good debt: credit cards and cars
Debt is not always good. It can be crippling for people who don’t manage their finances responsibly. Credit card companies prey on people who make the minimum payment. It may sound harsh, but only buy on credit if you can pay off the balance in full each month. If you spend more than you earn and need help managing your cash flow, see my related articles on envelope and detailed budgets.
Credit cards are not the only type of debt. Payday loans are even worse. They provide the money quickly but charge an exorbitant interest rate. Tax debt is also dangerous. As the Federal Trade Commission points out, tax relief companies raise thousands of dollars up front and promise to pay off your tax debt, but few actually deliver on that promise.
On a related note, have you seen the prices of cars and trucks these days? The average selling price of light vehicles in July was $ 38,378, according to Kelley Blue Book. If you’re overly concerned with driving your friends and neighbors, you might be tempted to buy a new car every few years. It is a dangerous proposition. The desire to “keep up with the Joneses” really does impact your ability to build long term wealth. When does it stop? After having a luxury car? Two of them?
A car depreciates quickly. If you buy it for $ 40,000, it might only be worth $ 30,000 a year later. Not only are you making monthly payments, but you will also get a lot less money when you sell it. In addition, there is no tax deduction for financing a personal vehicle (business purchases are another story).
The solution? Keep a new car for at least seven years. Save for the next car when you run out of payments on your current vehicle. Or, get ahead and buy a used car with more mileage. You might not be able to keep it that long, but you will most likely be able to negotiate a lower price.
When you are feeling overwhelmed with debt, there are steps you can take to clear negative items from your credit report. Kiplinger.com provides a excellent detailed guide about the factors that influence your credit score and the steps you can take to improve it.
Pay off debt or save?
OK. You see how some the debt is healthy. How do you know when to pay down debt rather than using that money to save more for retirement? Here are some considerations:
1. Build an emergency fund
Set aside enough money in a money market account for real emergencies. If “urgency” evokes too many negative emotions, rephrase it as a opportunity fund instead of. This can be an opportunity to start a side business, travel more, or achieve some other goal.
2. Get the employer match
Make sure you contribute enough to your employer’s pension plan to take full advantage of the match. It is obvious. Unfortunately, several employers have downsized or eliminated the company’s game in 2020 due to the pandemic. If your family is still financially strong enough to contribute to your 401 (k) plan at work, consider maintaining your normal pension contribution. This means you don’t have to remember to reinstate him when your employer resumes the 401 (k) match.
3. Weigh the rate of return on the investment against the interest rate on the debt.
This assumes that you have already set up an emergency fund and that you are taking advantage of your employer’s counterpart. Let’s say you have a credit card balance of $ 10,000 on which you are paying 15% non-deductible interest. By getting rid of those interest payments, you actually get a 15% return on your money! What sounds better… paying off that credit card or earning 7% on an investment account? In this case, eliminating high interest debt should be a higher priority.
4. Consider a hybrid approach
If you’re an intensely focused person who values logic over emotion, making the best financial decision is satisfying. Emotion may not enter the equation. You focus all of your energy on paying off “bad” debts.
For others, financial and emotional decisions work differently. What makes the most financial sense may not “feel” right. You have many intentions: pay off student debt, save for retirement, and finance your child’s education. Putting all the financial resources towards one goal may not make sense to you, emotionally. Instead, allocate a small amount of money for each goal.
Some clients who control their finances on a daily basis ask me, “Do I have to prepay my mortgage? “ That’s a good question, and I don’t always have a definitive answer. First, we focus on financial specifics like mortgage interest rate, loan term, and tax bracket. I also take into account the client’s investment schedule and risk tolerance. This makes it easy to tell them which decision is the best financially.
Yet we cannot ignore the emotional aspect. Why does the client want to prepay the mortgage? Is it to fulfill the dream of a lifetime of being debt free at 50? Go around the world in five years? What is the underlying ambition?
The bottom line is this: Debt, when used correctly, can be a great tool in achieving your financial goals.
Debt is just one of the many concepts we discuss in Redefining Family Wealth. Receive our FREE Wealth Building Tips and Getting Started Guide when you join the Redefining family patrimony mailing list.
CEO, WorthyNest LLC
Deborah L. Meyer, member of CFP®, CPA / PFS, CEPA and AFCPE®, is the award-winning author of Redefining Family Patrimony: A Parents Guide to a Useful Life. Deb is the CEO of WorthyNest®, a fee-only trust estate management company that helps Christian parents and Christian entrepreneurs across the United States integrate faith and family into financial decision-making. She also provides accounting, exit planning and tax strategies to family businesses through CPA SV services.