Sunday, November 1, 2009

There is no good debt, or is there?

One of the interesting facets of sports is the issue of belief. When an athlete goes steps onto the field, it is absolutely vital for them to believe they can do what needs to be done. That they can win, that they can beat the other guy. It's this belief that allows them to do their best, even when their best may well not be good enough.

Humans are funny that way. What's best for us to believe isn't always the truth.

So should we believe in good debt?

Debt is the ultimate complication, the antithesis of minimalism. It trades instant gratification for long-term commitments, commitments we may decide later we don't want to meet, but are forced to.

For a long time, the common understanding has been that there is such a thing as "good debt." The most commonly cited are mortgages and student loans.

Mortgages are theoretically good debt because they allow you to begin building equity in a home rather than paying rent that you never get back.

Student loans are theoretically good debt because they allow you to significantly increase your earnings potential

The problem is that the circumstances in which those are beneficial are narrow, but the concepts open the door to bigger problems.

A mortgage for a small home that can be easily afforded might be a good debt. But it opens up the door to rationalization. Given the chance, people will bend their thought process toward the result they want to reach. If they want to buy a house and a mortgage is the only way to do it, they'll convince themselves that they need it and can afford it.

The idea of a mortgage as good debt is what allows people to convince themselves that it is okay to buy a much bigger house than they actually need, which can be a crippling financial mistake and lead to a lifetime of extra work and stress to pay for that extra space. "Can afford it" continues to be a tricky concept, because we tend to be optimistic by nature. It's not enough to be able to afford the mortgage payment in good times. What if you lose your job? What if you are forced to change careers? What if you are forced to take a lower-paying job in the same field? Could you afford your mortgage then, at least for as long as it might take to sell the house in a tough buyers' real-estate market (several years)? Buying only the true minimum amount of house that you actually need can free you from those concerns.

Student loans are even more nefarious. It's an oft-cited statistic that college graduates make, on average, more than $1 million more in their lifetimes than those who stop at high school.

That is a bad statistic.

It's comparing apples with a bag of mixed fruit, at best. All high-school degrees are more or less interchangeable. Having a "college degree" could mean anything from an associate's degree in English to a Ph.D. in engineering. If you take out advanced postgraduate degrees in medical, legal and engineering professions, there isn't a lot of difference in the earnings of high-school and college graduates.

College is getting more expensive each year. The cost of a four-year degree can range well into the six figures, and few students are going to get away with less than a $30,000 investment. On a 30-year student loan at 3 percent interest, the true cost is going to be 2.12 times as much as the money borrowed.

A non-productive college degree is a six-figure luxury. It's easy for a college student to insist that they just can't be happy in life if they don't major in music theory at the expensive school all their friends are going to. Ask them again in 20 years if they would have rather had a paid-off house, a few nice vacations and a retirement date a decade closer instead, and their answer might be different.

College is the most important and most complex financial decision anyone will be asked to make, and 18-year-olds are rarely equipped to make that decision.

Car loans are by far the worst. Yes, they seem to be a necessity in modern society, especially for some people's jobs. But the total cost of the loan is usually twice the original price of the car, and the car depreciates considerably and consistently. And few people ever buy the minimum amount of car they need. For a few thousand dollars, tops, anyone can find a reliable and serviceable used car. With patience and a willingness to hunt for deals, even $1,000 should be easily enough. If you can't save that up to buy a car without debt, then you can't really afford the car.

In the end, most of us are better off telling ourselves there is no good personal debt

Take a look at that chart above, courtsey NPR. For five decades Americans took on more and more household debt. We, in short, have a problem.

Yes, some drugs have medicinal purposes. Would you tell an addict we there's good morphine and bad morphine? No, you tell him to go cold turkey.

Most of us should be doing the same with debt.

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