I have listened to and personally counseled thousands of families and individuals working to get out of debt or those who finally conquered the debt that plagued their families for years. It’s hard in today’s society to avoid credit card debt when it’s a very common practice to just “charge it” or take a loan and pay it later.
According to the Federal Reserve and other government statistics, the average household now owes $7,281 in credit card debt alone. (1) Now, that statistic includes every single American. There a few out there that have never had or have gotten rid of credit cards, so if you factor out those debt-free individuals, that number is more like $15,609. (1) Yikes!
Good Debt vs Bad Debt
It may sound crazy, but there is such a thing as good debt. In general, good debt happens when you purchase something that increases your net worth and helps you generate value. Good debt allows you to manage your finances more effectively, to leverage your wealth, to buy things you need and to handle emergencies.
I think examples of good debt are buying things that save you time and money (i.e. fixing things in your home to save on bills and up its resell value), investing in yourself with education (i.e. student loans with low interest rates). (2) And the No. 1 example of good debt is mortgage debt.
Home values have increased an average of 6.5 percent a year over the past 30 years. So when you borrow to buy a home, chances are that’s good debt. You’ll build value.- David Bach, CEO of Finish Rich Inc. (3)
I define “bad debt” as credit card debt, car loans or loans on anything that doesn’t appreciate (boats, consumable goods, etc.). Bad debt can also be any form of debt that carries a high interest rate or borrowing money from questionable sources like payday lenders and finance companies. Please, please…stay away from these types of companies.
Students and Debt
So where does bad debt start? What could entice someone to get something free today and pay for it tomorrow? Enter the college freshman.
A young freshman is at a football game and sees stands everywhere offering a free gift if they open up a $5,000 credit card. I’ve counseled many people that say this is exactly where their mound of debt all started. Think about it— the freshman got $5,000 on credit, but by the time they are out of school with interest it’s now $10,000 and on top of that there are student loans. So the now college graduate starts paying minimum payments on each of them, but then life happens and they need a major car repair or a new car, adding more and more debt.
Now as a 30 year old, they are still paying interest from a $5,000 credit card that was bought 12 years ago that purchased some new clothes, fun nights on the town, and some living expenses. Just think, if the money and interest used to pay these off over a long period were invested into a portfolio and allowed to grow in the other direction, where could that young freshmen be now?
This is the slippery slope of credit card debt. Life keeps happening and there’s no way of knowing what will happen next. If you start off with debt, it becomes easier to habitually keep adding more debt. From your first credit card in college to student loans to when you get married and have children, it gets harder and harder to pay down debt. And when the unthinkable happens like someone losing their job or any other excuses that life keeps adding up, you end up buried in so much debt that your income can’t overcome it in the near future and you feel trapped.
Thankfully, there have been measures like the Credit CARD Act of 2009 that help curb this. This act added protections that made it harder for students to get into debt by prohibiting things like unfair hikes in rates and keeping fees and rates transparent. (1)
Unfortunately, even the best laws and bills can’t protect us from ourselves and we end up pulling that credit card out too often from our wallet.
The Cost of Debt
Here’s the big problem that most people don’t think about when they are charging a new pair of jeans or plane tickets to California— interest. Interest is what buries us.
Every month that you make a partial payment on your credit account you are charged interest. (3) The average household is paying almost $7,000 a year in interest alone—that’s nine percent of an average income. (4)
I’m sure you weren’t taking that $7,000 into consideration when you planned your budget, so where is that supposed to come from? And most likely, the amount you end up paying in interest (not even thinking about late fees or penalties) is going to far exceed the value of whatever you bought to gain it.
It’s easy to see how credit cards have become one of the most expensive types of debt. But believe it or not, there was a time not so long ago when people thought having a little debt could get them get rich.
Why It Used to Be Considered Good
What I’ve noticed over the past 20 years is that during the ‘90s and up until the 2008 credit crisis in the economy, debt became the preferred strategy to build net worth. With a rising stock market in the ‘90s followed by a booming housing market in the 2000s, people were using debt to buy investments. And getting that debt came very easily.
Someone looking to get into real estate at that time could get a loan on a house for 100 percent and use that money to furnish their “investment” properties. They figured they could buy a space for $300,000 and then turn and sell it the next year for $400,000.
Instead of being viewed as risky, using debt was necessary to build net worth and get ahead. Because they were using all their resources elsewhere, people needed credit cards to furnish their homes, pay basic monthly bills and of course travel. They thought, “I will pay this credit card off when this house sells, or when my investment account grows another 10 percent.” And the debt kept piling up. Sadly, when the market unraveled, people all across the country lost their jobs, weren’t able to resell their investments and went into bankruptcy.
Ways to Avoid Debt
I realize that sometimes there are no options other than utilizing debt for certain life events. What I’m trying to say is that it’s not ok to become so comfortable with debt that it’s your go-to option as long as you can get that proverbial free money. You should feel that pain of debt and exhaust every option before deciding to go further down this road.
My goal is to help people find financial freedom where their money doesn’t control them and they are not a slave to the lender. Here are a couple ways to stays out of debt:
Have your Buckets in place: Get your Bucket 1, three to six months’ emergency fund set to go. Have your Bucket 2 filled with money you’re saving for your kid’s college and paying off your home. And keep putting 15 to 20 percent of your income into Bucket 3 for retirement.
Take inventory of the debt you have: Before we do anything else, we need to knock out credit cards one by one. Figure out which one has highest interest rate and lowest balance and do whatever it takes to start paying extra on that card each month and then move onto the next one. Dave Ramsey calls it the debt snowball. (5)
Stop carrying your credit cards: Do not spend any more money on your credit card. Get a couple thousand dollars in the bank to cover unexpected events and forget that your credit card is even option.
If you do invest in a home, do what our parents did and wait until you can afford it: Buy your first home when you can put down 20 percent and the mortgage will be no more than 25 to 30 percent of your take home pay. This will help make you recession proof.
- The State of American Credit Card Debt in 2015 by Holly Johnson
- Good Debt vs. Bad Debt by Debt.org
- Good Debt vs. Bad Debt by Bankrate.com
- 2015 American Household Credit Card Debt Study by Nerdwallet.com
- How the Debt Snowball Method Works by DaveRamsey.com
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of David Adams and not necessarily those of Raymond James. Please consult with your financial professional about your individual situation. Raymond James is not affiliated with and does not endorse the opinions or services of Dave Ramsey.