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We hear it all the time: “I feel like I’m not actually an adult because I have debt. And debt is bad!” Do you resonate with that?
Well… we’re here to tell you a few things about debt that just might blow your freakin’ mind.
It’s Not the 80s Anymore, Mom
Do you have parents, grandparents, or older family members/peers in your life who talk about “debt being dumb”? Maybe you’ve heard a shall-not-be-named “money guru” say that and thought, “Well crap, I must be dumb.”
We take issue with this approach to debt. Why? Because it’s not the same world anymore, and sometimes debt is kinda smart. Yeah, we said it.
From the early 70s all the way up until the financial crisis in 2008, there were about 40 years of high interest rates. These interest rates were way higher than historical averages — and even what we’re working with now. That means, if you’re a Millennial, your parents were maybe paying 14% interest on their mortgage. Insane, right?!
What’s even crazier is that today, we’re looking at the lowest interest rates in over 200 years. So, when we talk about debt “back then” and debt nowadays, we’re talking about apples and oranges.
This means that owning a house with a 4% mortgage is wayyyyyy better than owning one like your parents did (and probably paid off) at 14%. This means that your car loan at 4 or 5% is wayyyyy more affordable than your dad’s old T-Bird.
And you know what? The cost of college has increased 260% since 1980. So thanks, Aunt Linda, for the story about how you paid your way through college, but the reality is we need loans to get that same education.
So, when we talk about debt, know that we are actually talking about interest rates. And interest rates really are just a game you gotta play.
How to Play the Interest Game
To put it simply, interest is the cost of acquiring money.
How much does it cost to borrow the money you need? How much will it cost you to take out a loan to buy a house? How much does it cost to get money to pay for your education? And is the interest worth that cost to you?
The Good, Bad, and Ugly Debt
We’re not telling you to ignore your debt if you have, let’s say, a 0% interest rate on your new car or home furniture. What we are saying is that you shouldn’t push yourself to the brink to pay down debt that has a low interest rate.
But yeah, sometimes we make mistakes and go into credit card debt over stuff like a new phone and some killer blue suede shoes. Those are the kinds of debt that we want to avoid — and pay off faster.
Other times, things like predatory lending can get us in a bind and we may be paying 20-30% on things like cars, payday loans, and credit cards. So that leads us into the good, the bad, and the ugly.
“GOOD” DEBT (AND YES, WE USE THAT TERM LOOSELY) INCLUDES:
- Auto loan
- Student loan
- Business credit cards or loans (with good interest rates)
These are used to improve your situation.
“BAD” DEBT INCLUDES:
- Adjustable rate mortgage (you buy a house and the rate can be changed over time, sometimes ridiculously high)
- High interest student loans (that you’re just paying the minimums on)
- High interest car loans (this happens if you have bad or no credit)
A good frame of reference for bad debt: anything higher than 5%. If that’s where you’re at with a loan, it might be good to buckle down and pay more.
“UGLY” DEBT INCLUDES:
- Credit card debt
- Store credit debt
- Payday loans
“Ugly” debt usually is qualified by interest rates in the 20-30% range, and they require you to do some work to get them paid down. Why? Because you’re paying up to a third more than you spent — that “cost” associated with the money is totally not worth it.
But now that you know which debt you should be prioritizing, how much more should you be paying to your good/bad/ugly debt?
How Much Should We Be Paying Towards Debt?
This doesn’t apply to every person, but a good rule of thumb is to spend about 5-15% of your income on debt. This includes your credit cards, your student loans, your car payment, etc. It does not include your mortgage, which is a separate category in your budget.
And, again, it depends on the interest rate! Are you at a smaller interest rate like 4%, or a higher rate at more than 17%? If you’re at 6% or higher, you should probably lean more towards the 15% of your income range going to debt repayment. But not at the cost of your savings!
Remember your savings and investing. You should be saving (and giving) about 25% of your income but, if you have a lot of high interest debt, you might want to cut back on that investing. Then, once those higher interest debts are paid off, you can ramp up the savings and pay down the other lower interest rate debts over time. Why do we say this?
Because investing can net you 3-6% on average… which negates any sort of interest you’ll be spending on low interest debt.
How? Because as you compound interest on your savings and investments — meaning you grow your accounts because you’re getting paid interest into them — you continue to add more money, and get paid interest on those higher amounts. You’re making money on the money you’ve earned. It’s freakin’ magical. You know what’s not magical? Going broke to pay off low-interest debt.
Debt Isn’t Your Risk; It’s the Financial Institution’s
People think all debt is bad because it’s a financial “burden” that rests on them. But that’s not the truth. The party carrying the real burden are the banks that loan us the money. Essentially, you could never pay that money back (sure, you’d be screwed, but they’d be out the money), so they are the ones more at risk than you are.
We hear this all the time when we see Facebook rants about how “China owns our debt!” What you need to understand is that we don’t have to pay back that debt right now. We have more money in our bank account because they (China or the banks) are holding that debt for us. This frees up more cash in our accounts to pay them back, but also still keeps living.
And there’s psychological value in knowing that we can pay things back over time — making it possible for us to do other things in life, like buy a house, have a baby, build a business, and so on. We’re not saying don’t pay down your debt, or to only ever pay the minimums. But we are saying that you can do it at a pace that allows you to fill your other buckets.
Don’t Pay Down Debt at the Risk of Your Other Needs
We’re just gonna say it: We have a problem with some of the more popular debt repayment advice out there. We know that having an emergency fund so you don’t have to go into credit card debt in case of an emergency is much more important than just paying off your credit card right now.
Being able to afford the roof over your head while also paying down your student loan debt is more important than going all in to pay down your debt — and losing your roof in the process.
And building long-term wealth is more important than paying down “good debt” for the sake of saying you are debt-free. #JustSayin
The biggest advantage of being young is that you can save so much, and therefore gain so much compound interest, that you can build vast amounts of wealth over time. But if you’re focused on paying back “good” low interest debt, you’re losing out on those prime saving years — and setting yourself up for more risk if something not-so-fun happens.
So let’s reframe your debt: low-interest debt can give you power and leverage, rather than be a burden. It’s not 1985 anymore, so don’t let older generations tell you all debt is bad. Instead, lay out your debt, look at the interest rates, and figure out which debt gives you power and which debt is taking AWAY your power.