Debunking 'All Debt is Bad' and Other Common Myths

We often hear about the dangers of too much debt. We can make dramatic decisions to avoid debt altogether; however, that may be to our detriment. Not all debt is bad. Consider a few situations when debt can help improve your overall financial situation.

Debt on a home can build your wealth

Debt can help make you wealthy. One of the largest debts you can take on is a mortgage. Debt can help you acquire one of the largest assets you may ever own: your home. With a down payment and approval from a lender, you will be able to make a large purchase. Generally speaking, homes appreciate in value.

If you’re fortunate to live in a community with modest house prices, you may be able to buy a home early in life and begin paying it off over a 30-year mortgage. By the time you retire, your home will be paid off. You will then own the home free and clear.

If you’re lucky enough to live in a city where home prices are appreciating quickly, then your home could become a substantial asset and an important part of your retirement plan. Homes in cities like Denver and San Francisco are currently growing at very fast rates — sometimes more than 10% per year. The average increase in home values across the U.S. was between 3% and 4% per year for the last couple of years.[i]

A lender may prohibit a borrower from taking a debt payment that is too large a percentage of her income. A good rule of thumb is to visit a lender and find out how large of a loan you can comfortably afford. For most people buying their first home, the average mortgage payment is 35–40% of income.[ii]

Mortgages are fixed or variable rate loans from banks. A variable rate loan is usually lower than a fixed rate loan — but the interest rate, and the mortgage payments, could increase later if interest rates rise. At today’s low interest rates, people can afford more home than at almost any other time in history.

Homes and other investment assets grow at compounding interest rates. This means that the value of a home, over long periods of time, may be much larger than it might first appear. And because loans are simple interest, not compounding, debt payments don’t increase as the home value increases. This can build a lot of wealth in the form of home equity.

An example of how this works

To buy a $200,000 home, a person could choose a rate based upon their down payment, but for this example, we will assume a 20% down payment, or $40,000. Members of the military and first-time home buyers may often have a much smaller down payment. Make sure to ask about these alternate types of home loans. A lender loans the difference, in our example, $160,000, at market competitive rates. Today, rates are approximately 3% — some much lower and some higher. A monthly payment includes interest and, in most cases, principal, which pays down the loan over time. In our example, a 30-year mortgage requires a monthly payment of $675. It pays to shop around for a mortgage with an interest rate that works best for you.

Over the next 5, 10 and 20 years, the total principal and interest payments and the amount remaining on the loan read as follows:

While these numbers are large, remember a renter would make approximately the same payment for rent as an owner would to borrow and purchase a home. And, of course, the home requires additional insurance, maintenance costs, utilities and other expenses that will add to these costs.The big advantage, of course, is appreciation—increase in home value. If a $200,000 home appreciates at 3%, 5% or 7% in value, over 5, 10 or 20 years you could see a significant increase in your wealth.

Debt can create wealth. In this example, in a quickly appreciating housing market, more than three-quarters of a million dollars more! Subtract the total payments and remaining principal, and the homeowner has a nice nest egg for retirement and for emergencies.[iii]

Student debt is not as bad as you might think

Right now, student loan debt is receiving a lot of bad press. Many students are graduating with loans that are many tens of thousands of dollars in size, without an income to pay for it. And in a recent survey, more than half of the respondents claimed that taking out student debt was not worth it![iv]

The size of student debt has ballooned over recent decades. Many people are alarmed by the statistics.[v] Since 2003, Americans have increased their student loan debt by 356%!

Sometimes perspective helps. The vast majority of Americans, 85% of us, have no student loans. Of the Americans who have student loans:[vi]

• 1% are greater than $100,000
• 4% are between $25,000 and $100,000
• 11% are less than $25,000 in size.

Particularly for vocational school, the financial case for taking on student debt is an easy case to make. The average wages for people who have college degrees is significantly higher than for those who do not. And the more the education, the better the average income — as it has been for years. People with a professional degree make more than three times the income of a high school graduate, on average. Some of them earn substantially more than that.[vii]

Student loans are either public or private. Public loans are subsidized by the federal government. Roughly 30% of college students take out federally subsidized student loans.[viii] Some students are prohibited because their parents’ income or assets are too high. Others may not know about the subsidized loans. These loans have more lenient payback rules and lower interest rates than private loans.

An example of how student debt works

Similar to the debt story we just looked at with homes, student debt is paid back at fixed rates. The value of the education is in the income from a job. Employers usually give raises year after year. In other words, jobs provide a compounding income. Thus, even if a student borrows money at a high interest rate it may make financial sense for her to do so.

Student loans might carry a 5% or 6% interest rate today. Many rates are lower and some are higher. An employer may make modest pay raises for an employee, say 2%. The average student loan is $30,000. The average high school graduate earns $38,000 per year. The average income for a bachelor’s degree is $73,000 per year. A student had to forego four years of income to go to school.

Within a single year, a college graduate could pay off the loan, but that’s not realistic. Most student loans have a 10-year amortization schedule. Let’s assume our college graduate pays off a 6% loan in five years — she would have paid about $34,800 in principal and interest and foregone nearly $160,000 of income she otherwise could have earned by not going to college. Within six years after graduation, a typical college graduate has more than offset the lost income and loan costs.

College is almost mandatory in today’s high-tech, service economy. Our college graduate who took a loan has years of increased income potential ahead of her.

General rules for student loans

As a general rule, don’t borrow more than a year’s worth of expected post-graduate income. Do consider using federally subsidized Stafford loans, which are not income dependent. You likely do not want to increase your home equity debt to pay for your student’s college. Put together a college budget, including a plan for paying back the debt.[ix]

Clearly not good debt … car loans

All that being said, clearly there are a couple of types of debt that are not good financial decisions: car debt and credit card debt.

Many people have to take a loan to buy a reliable car in order to get to work because they have not saved enough money to pay for the car outright. Furthermore, today’s cars are expensive! But an automobile is a depreciating asset and the loan payments are fixed. By the time a car payment is over, a person has spent a considerable amount of money towards mobility!

The average car price is $36,000.[x] The average interest rate for a car loan is in the mid 4% range.[xi] As prices increase, the length of loans has increased as well. Eighty-five percent of automobile loans take 5 years or longer to pay back.[xii] Average car depreciation is famously terrible. Although data is hard to find, auctioned cars sell for a quarter of what they were worth brand new![xiii]

Quick math paints a dire picture for the true cost of a car loan. The average result would be spending $41k for a $9k asset. This does not include the taxes, which vary by state, and maintenance, which can easily increase the cost by thousands of dollars. For an average price ($36k), average loan terms (5 years at 4.5%), the monthly payments would be $671.15.

Clearly, the value of an average car is in the mobility — not the vehicle itself. If you can find a way to live with a less-than-brand-new vehicle, you will make a prudent financial choice. And if you can do it without a loan, all the better for you.

Another bad idea, credit card debt

Americans carry $1 trillion in credit card debt. The average interest rate is 15%.[xiv] But this only scratches the surface of the problem. Credit card debt uses compounding—not simple—interest rates. When you don’t pay off the card, the size of the loan increases by the interest rate. Imagine the opposite of the example we used at the beginning of this story—for homes—only worse!

A $10,000 credit card balance due at the average 15% interest rate turns into a loan the size of a mortgage if a person only makes that $50 minimum monthly payment.

Don’t make this mistake! Consider talking to a CFP® professional if you’re upside down with credit card debt.

In summary

Not all debt is bad. At least two types of debt can help build substantial wealth: debt related to home ownership and student loan debt. Both of these types of debt can be very healthy to a person’s real-life financial plans. For more information, speak with a Certified Financial Planning practitioner.

Investment advisory services offered through A & I Financial Services LLC, registered investment advisor. Securities provided through Geneos Wealth Management Inc., member FINRA, SIPC.

[i] Cushman and Wakefield, US Economic Outlook and Implications for Property Markets, https://www.cushmanwakefield.com/en/united-states/insights/us-econ-outlook

[ii] Share of income spent on starter, trade-up and premium homes in the United States from Q1 2017 to Q1 2019, Trulia: https://www.trulia.com/research/inventory-and-price-watch-q1-2019/

[iii] For a different perspective, read this article on Investopedia. https://www.investopedia.com/articles/pf/12/good-debt-bad-debt.asp

[iv] Thinking about your current financial situation, was taking on student loan debt worth it for you, or not worth it? https://morningconsult.com/wp-content/uploads/2019/10/190963_crosstabs_MONEY_Adults_v3_JB-1.pdf

[v] Student Loan Debt Since 2003: https://www.statista.com/chart/22984/student-loan-debt-since-2003/

[vi] 2020 Planning and Progress Study - Student Debt: http://news.northwesternmutual.com/download/NM+P%26PS+Wave+4_Student+Debt.pdf

[vii] US Census Bureau, released September 2020. http://www.census.gov/data/tables/time-series/demo/income-poverty/cps-pinc/pinc-04.html

[viii] Percentage of college students who took out of federal loans, year-over-year, in the United States between 2010 and 2020. https://www.salliemae.com/assets/research/HAP/HowAmericaPaysforCollege2020.pdf

[ix] Interview with Cameron Morgan, college planning expert. https://www.assetsandincome.com/our-team/cameron-morgan/

[x] New vehicle average selling price in the United States from 2016 to 2019 https://www.nada.org/WorkArea/DownloadAsset.aspx?id=21474861098

[xi] Interest rates on auto loans in the United States from September 2017 to September 2020 http://www.bankrate.com/finance/auto/current-interest-rates.aspx

[xii] Distribution of auto loan terms of new and used vehicles with financing in the United States in 2nd quarter of 2020 https://www.experian.com/content/dam/marketing/na/automotive/quarterly-webinars/credit-trends/2020-q2-safm-final.pdf

[xiii] Auctioned car prices as a percentage of their original prices in the United Kingdom (UK) from August 2014 to January 2016 http://www.nama-uk.com

[xiv] Commercial bank interest rate on credit card plans in the United States from 1995 to 2019 https://fred.stlouisfed.org/series/TERMCBCCALLNS#0