The infamous D-Word, debt—an inanimate thing that can cripple our finances and heavily influence how we feel about money and ourselves. It’s rare to find someone who hasn’t experienced some form of hardship due to debt, either personally or through a close relationship. The pressure society places on this inanimate thing is quite impressive. In some social circles, debt is seen as a contagious plague that sets out to ruin your finances one payment at a time. However, the truth is that debt is not inherently bad.
That’s right! The thing many believe to be the sole reason for financial failure is not the boogeyman it’s made out to be. Debt is a financial tool, and like all tools, it has a time and place to be used. If you only have a hammer, everything becomes a nail. In a not-so-perfect world, you’ll eventually need a different tool for a different job. It’s the same concept with our financial tools; there’s a right place and a right time for everything.
That being said, if you find yourself in a situation of crippling debt, it means the tool was used incorrectly. Debt has become a glorified boogeyman because of human nature’s tendency to overindulge. Debt allows us to buy something today that we should have saved up for tomorrow. This concept, known as immediate gratification, means we benefit from an action immediately rather than having to delay the reward over time, known as delayed gratification. Most financial tools are connected to either immediate or delayed gratification, each coming with some form of cost.
The Practical Side of Debt
With debt, the cost of immediate reward is in the form of an interest rate—a percentage extra that we owe back to the bank that lent us the funds for our purchase. Not only is this a good source of revenue for the bank, but by lending us the money, they’re giving up their ability to use those funds today. In other words, the bank delays its reward to the future while you benefit from the loan today. There’s a trade-off with almost everything, but again, there’s a right place and a right time for every financial tool.
Debt allows us to buy homes, vehicles, fund businesses, make large purchases, and cover everyday spending. In return for not waiting to save for multiple years, we owe the lender a payment for delaying their reward. Interest is also not inherently bad. Yes, you pay more tomorrow than you would have today, but consider the rate of inflation before condemning interest.
Inflation, simply the change in prices year-to-year, sounds scarier than it is. Think of inflation as the cost of waiting if you don’t use debt to finance your purchase. The historical average for inflation in the United States is around 3% per year, the target rate the government aims to maintain annually. To put this into perspective, imagine using debt to purchase a home. In 1994, the average home price was around $154,000. If you purchased the home with 3.25% down ($5,000) at a 7% interest rate (the rough average over the past 30 years) for a monthly payment of $1,000, you’d pay a total of $360,000 ($149,000 in principal plus $211,000 in interest). You might think interest is a bad thing, but let’s highlight the alternative.
If you saved for 30 years instead of paying interest, you’d avoid the interest but lose to inflation. Taking the same $154,000 from 1994 and factoring in 30 years of inflation, it would be equivalent to $332,505 today. Essentially, you’d pay just shy of $30,000 in interest to get the home 30 years sooner.
This simple example doesn’t account for factors like real estate value potentially outpacing inflation, but it shows the cost of waiting. The worth of the cost of waiting often comes down to the interest rate. High-interest debt like credit cards, typically seen as ‘bad debt,’ can quickly get you into trouble. Conversely, mortgages and student loans can be seen as ‘good debt’ since they offer appreciation in real estate value and increased income potential.
Now that you understand a bit more about debt, it’s important to note that it can be bad for some people. Debt can be a powerful tool if used responsibly. Your debt payments should never exceed your income, and a good rule of thumb is to keep all debt payments below 50% of your income.