Debt

You’ve seen them everywhere. The ads comparing a 30-year mortgage to a 15-year. By now, most of us have a handle on the simple math. The typical 15-year mortgage comes with a lower interest rate than 30-year. Interest is front-loaded on the amortization schedule (in simple terms, when you look at your monthly payment, most of your payment is applied to interest rather than paying down the principal). Over time, more and more of your payment is going to principal. So why compare these options?

Let’s start with the overall interest paid over the life of a loan. Simple math (there are online calculators to do this is well) shows that a 15-year note can save you tens, if not hundreds of thousands of dollars depending on the loan amount. The caveat: your monthly payment will be substantially higher in most cases. Even when the financial picture looks good, that could be a difficult commitment. After all, you are locked into that payment without many options if you lose your job or things get tough. Also, lending guidelines and restrictions may make it more difficult to get approved for the payment in the first place.

With all of that being said, it can certainly make a lot of sense to go for the shorter repayment term. Don’t forget about the option of just making additional principal payments on a 30-year loan (requires discipline, but it would almost result in the same outcome as the shorter note). So, what does this all have to do with the concept of “good debt” and is there such a thing?

In another post, we will get deeper into the concept of leverage. This is simply a method of acquiring property via a loan compared to using your current capital. Real estate investors look at this ratio often as a means of weighing investment risk (and they should). But for the average homeowner evaluating their primary residence, how should you feel about debt? Many advisors will tell you having a mortgage is OK, and for most of us it’s not really a choice if you want to own a home. Who has hundreds of thousands of dollars laying around? But if you listen to some of the heavy influencers out there in the financial space, there is an emphasis on becoming debt free. Debt comes with an ugly connotation, because it is usually expensive and hinders your long-term financial independence goals. Not only are your funds going to interest payments, but you are losing out on the opportunity cost of what you could do with those funds if you weren’t servicing debt. In short: attack expensive debt quickly i.e. credit cards and lines of credit that carry a high interest rate.

So, is a mortgage “good debt”? Let’s go as far as to say that it’s usually necessary, and always a good idea to do the math. Understanding your options, weighing them against each other, and figuring out the best path for your financial picture is the name of the game. This can usually be done in a written financial plan which simulates the different outcomes over the long-term. In most cases, it works out better to approach debt quickly. If you can’t do that, then seeking the least expensive debt is the next best thing. We are experiencing some very interesting times right now, and interest rates are still very low. If you have not looked at your current rate for a potential refinance, it may be a good idea to do so. Just be sure to do the math!

Let me start by saying that I know how harmful credit cards can be. The average credit card balance per American household is approximately $5700. I’m assuming that is going to go up in the near-future due to the aftermath of a pandemic. Unemployment is up to record highs. Uncertainty is everywhere. Businesses have folded altogether. And another stimulus is unlikely to be enough for most people struggling currently. A lot of people are on their way to what we are calling the cash cliff. Gloomy enough picture yet?

So what do we do when we have a cash issue? We borrow (that’s not a suggestion, it’s a commentary on the most common result). The only other alternative is to sell your assets to free up some cash. When we borrow, we create debt. If there is no way to avoid creating debt, then the next best thing is to make sure it is as INEXPENSIVE as possible. Interest rates are so low right now, and the banks (believe it or not) are hurting too. One of my all-time favorite strategies was the credit card game. How does it work? Is it still available?

Things are always subject to change, but when I was still in school and working two jobs (making next to nothing), there were times when big purchases were necessary. The time-tested conventional wisdom was that borrowing money for free was not a bad idea, as long as you can pay it back. This brought me to the zero-interest financing solution.

Now let’s start with a nice disclaimer: I AM NOT TALKING ABOUT VEHICLE PURCHASES ADVERTISED AT 0% APR INTEREST. I can go into an entirely separate post about why that isn’t actually a good deal for you to consider. I am, however, referring to 0% INTRO APR credit cards with reward/bonus points attached. These are commonly offered by big banks, and I have utilized these offers in the past.

The way it works: You get a NEW credit card (so obviously your personal credit needs to be solid enough to qualify). That new card is for new purchases/spending only. This replaces your existing cards with higher interest rates as your new method of paying for your everyday needs (gas, groceries, etc.). These cards tend to come with a 0% interest rate for a certain number of months, usually up to a year. They also often come with a BONUS reward if you spend a certain dollar amount in the first 60-90 days. This is literally free cash back to you if done right.

Now the question of how to handle the debt (old card and new). First of all, that 0% intro APR card may have a clause that is actually accruing interest if the entire balance is not paid when the intro term ends. READ CAREFULLY. If this is the case, you better be sure you have the funds to pay off this new card down the road. A Budget is crucial. And, this new card is for essentials, not to go shopping. If there isn’t a balloon term on the end, and a regular APR kicks in later (reasonable, not 20%) then it’s not the end of the world if you still have a balance when the 0% ends. Why? Because you should have been doing the following all along: Tackling the old credit card debt with the higher interest rate.

This takes a methodical, strategic approach to accomplish. In simple terms, you are better off finding a way to consolidate debt be refinancing or condensing multiple expensive lines into one with a lower interest rate. Most of us don’t see just how expensive and harmful it can be to carry debt like that. A written financial plan is a good way to see just how harmful it is.

In another post, I will address the concepts of debts around bigger purchases (home, auto, student loans) because there is often a time and a place for it. My argument is not that all debt is bad (although I do say to avoid it if possible). My position is that expensive debt is bad, and should typically be the first area of opportunity to approach in your quest to improve your overall financial picture.