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Two Simple Rules for Safely Managing Debt

I think it’s fair to say that we may be approaching another debt crisis in the U.S. According to the New York Federal Reserve, as of Q1 2018 credit card debt stood at $792 billion, auto loan debt at $1,188 billion, student loan debt at $1,453 billion, and mortgage debt at a whopping $8,982 billion (that’s almost nine trillion dollars). Only home equity lines of credit, at $396 billion, and credit card debt are below their previous peaks set in 2008.

This should not come as a surprise given the amount of money the Fed has been pumping into the economy since 2008. When financial institutions are allowed to lend money at 4.5% (mortgages), 8% (student loans), and higher (credit cards), while the cost of that money to them is less than 2%, naturally they will push as many loans as possible to consumers. The problem is that we consumers were never taught in school how to manage debt safely. If you follow the two rules outlined here, you should be able to utilize debt to your advantage without taking on undo risk.

Debt rule #1: Do not borrow money for any asset that is not expected to appreciate in value throughout the loan period.

What are appreciating assets? Real estate, stocks and bonds, and commodities such as energy products and raw materials generally increase in value over time. Then there are artworks, jewelry, and other collectables whose future value may appreciate or depreciate depending on changing collector preferences. Just about everything else – including non-collectable cars, furniture, boats, and most technology-based products – declines in value after purchase due to advances in technology and in production that enable the creation of lower-priced or better-performing substitutes in the future.

Why is it a problem to borrow money to pay for a depreciating asset? Simply because you cannot utilize the asset to help defray the cost of the loan should an unforeseen circumstance arise. Suppose you are holding a car loan that is halfway paid off. At that point the amount owed is likely to be more than the current value of the car. If you were to lose your job or encounter unexpected healthcare expenses, you’d risk the loss of the car or, in the worst case, bankruptcy.

Is it safe to use credit cards to pay for household items? Only if you pay off the balance in full every month. Otherwise those items may end up costing you a lot more than you expected or can afford.

Unfortunately, even for appreciating assets, the time period may not always coincide with the loan period. I would consider fifteen and thirty-year home mortgages to be generally safe since home prices rarely decline (or remain depressed) for such long periods. I would not recommend borrowing money to invest in stocks and bonds, however. Although their prices historically increase in value long-term, they can fluctuate pretty wildly over the short-term. That is what destroyed Lehman Brothers in 2008.

I am often asked about student debt and how it relates to debt rule #1. When you incur student debt, in what asset are you investing? Yourself! And are you an appreciating asset? I would certainly hope so! Most students’ net worth twenty years after graduation is a lot higher than it was when they were in school. Therefore student debt is a perfectly acceptable way of financing higher education, as long as you also follow rule #2.

Debt rule #2: Do not borrow money before having a well-thought out plan to pay it back.

This is where most borrowing mistakes are made. When applying for a home mortgage, do you borrow the maximum amount the lender offers to provide you? Or alternatively do you consider (1) not only all your other current expenses but also how much you need to be saving for your children’s future education needs as well as for your own retirement, as well as (2) the likelihood of remaining with your current employer and how much your income might (or might not) grow over the next 30 years? By limiting the amount to be borrowed based on your expected ability to maintain the payments, you can avoid the likelihood of becoming house poor now and/or being forced to sell the house in the future.

Borrowing for college also requires careful planning. How much student debt can you truly afford? Estimating the income you can get from a particular career, both initially and over time, can be valuable in determining the maximum debt to safely incur for a college education.

For most everything else, if you have to borrow to buy it, first consider a cheaper alternative for which you can pay cash.

Always remember that debt is not free money. You may face difficult times in your life when you have no choice other than to borrow money in order to stay alive. But for the most part, managing debt is simply about making realistic decisions about what you can and cannot afford. If you follow just these two principles, you will protect yourself from having debt overwhelm your lifestyle.



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