It doesn’t take a finance expert to know that it’s probably a good idea to stay as far away from debt as possible. With that being said, for most ordinary people, it is impossible to avoid. Thankfully, not all debt is evil! Below I will describe the types of debt that are acceptable and types you should try to stay away from at all costs.
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Acceptable Forms of Debt:
1. Student Loan Debt
College is not the best idea for everyone, but there’s no debating in today’s world, college graduates earn more over their careers than non college grads. This doesn’t mean it’s smart to go take out a loan for a sociology or art history degree from a liberal arts school. Have a plan and get an education that will present future opportunities in your desired field. Masters and MBA programs are tricky because they can be great investments or they can be terrible ones (much like college). Again, I would make sure there is a defined reason for you to get another degree and that you go to a top-ranked school. When you take on debt, be sure to pay back the higher interest rates first and if rates are above 5-6%, explore refinancing them.
2. Mortgage
Everyone needs a place to live and buying is typically a very sound financial decision. With that being said, you normally need to live there at least 5 years if you want to recoup your initial costs. Also, I would strive to make your total house payment (mortgage, insurance, taxes, potential PMI) less than 30% of your TAKE HOME pay every month. Don’t trust the online pre-approval calculators or what the bank is willing to lend you. Calculate it yourself.
3. Medical Costs
This is one thing we can’t control and can unfortunately get very expensive. Hopefully you are funding an HSA and an emergency fund that can cover any expense, but realistically sometimes you won’t have the full amount available on the spot. Making payments here might be the only option and hopefully this means you’re healthy, which is much more important than finances.
Types of debt to stay away from:
1. Car Loans
This one is tricky because most people have them (myself included) and handle them appropriately, but I put it here because sadly most don’t handle them appropriately. When I say handle them appropriately, I mean you have most or all of the money up-front in cash, but you choose to take out a loan because of the extremely low interest rates (0-3% in some cases). You take the excess money and invest it somewhere where on average, you would generate better than a 3% return. Unfortunately, often times people see a low monthly payment and spend way too much on a car. What happens is the car quickly loses value and then they’re stuck. If the loan was for $34,000 and the car was originally worth $39,000, after about 90 days that car might be worth $31,000 and then the person is underwater and can’t get out of his loan without forking out cash he most likely doesn’t have on hand. I don’t think I need to say much else besides don’t do that. Stay cheap and buy a reliable car (Toyota, Honda) that will last you a long time.
2. Borrowing from 401k/IRA
I would try very, very hard not to ever touch your retirement savings. This money is supposed to support you in your later years; only take it out if it is absolutely necessary.
3. Credit Card Debt
One of the worst forms of debt in my opinion and typically is an indicator that you might want to take a serious look at your finances. Credit card interest rates can be upwards of 15%, putting you in a really, really bad financial situation. Set up auto pay on your account and make sure that gets paid every month. Carrying a balance “just for a month” is a very slippery slope.
4. Payday Loans
Desperate situations call for desperate measures and this might be your only option. It isn’t a good option. Try to avoid it, but I understand in some cases it has to be done.
As always, I’ll leave you with a quote – this one from Ogden Nash. “Some debts are fun when you are acquiring them, but none are fun when you set about retiring them.”
