Debt can be a good thing . . . Seriously! The problem with debt is that it rarely is – good. Most of the time what began as a means to a better end turns into a source of paralyzing, soul-crushing anxiety that cripples and provides wall-to-wall distraction from every decent minute you have.
So when is debt ever good?
Debt is good only if it’s used to obtain an appreciating asset and the interest is tax deductible. For example, a home (mortgage) or an education (student loan).
Debt is not so good when it’s used to obtain a depreciating pile metal – like a car or something that’s not permanent, like a meal.
The financial industry makes taking on debt incorrectly, randomly or in too large a proportion SO easy. Anyone can borrow far more than they might ever be able to repay. Case-in-point, ‘student loans.’ The penalty for borrowing more than appropriate isn’t that bad. Consumers who overspend simply file Bankruptcy. Only two generations ago a place called ‘Debtors Prison’ existed. My grandmother used to threaten, “They’ll haul you off to the poor house.” Images of Oliver Twist ran through my head like wildfire.
Since nobody wants to go to the poor house or have his or her credit and financial capability hijacked by an electronic corporate agreement with no actual person holding the reins; here are your directions for debt consumption – from a professional.
First, There are two different sorts of debt; Debt for the sake of acquisition, and debt for the sake of building assets. An example of the first is consumer debt, department store credit cards, restaurant meals, things that buy that do not appreciate in value. This includes cars, furniture, clothing, vacations, etc.
Debt for the sake of building assets means debt taken on to acquire an asset that will appreciate. Examples of this are some homes and real estate, education, collectibles like artwork or other classic valuables (not your collection of antique canning jars or your barn full of old motorcycle parts from the 80s). Cars only appreciate if they are the collectible sort (think Jay Leno). Your run-of-the-mill commuter vehicle doesn’t count.
Next, there are more layers to debt than those included in the borrowing contract. Don’t forget to consider inflation when calculating debt. Most consider the effects of inflation on cash accounts or long term holdings, but inflation also effects everything- including debt. It quietly increases the Lost Opportunity Cost of money we allocate to repay debt making the interest rate connected with debt functionally higher than that listed by the lender. Inflation is also part of what creates appreciation. Assets can also depreciate. Be careful not to confuse the two and to assess appreciation correctly.
Third; debt, like any financial strategy, must be carried correctly. One of the best lessons of any debt obligation should be to understand how much debt you can handle. Here is how to figure out your limit.
Gross Annual income – Gross savings amount = Gross spendable Income.Debt should not be more than 25% of your Gross Spendable Income.
100% = income – 15% goes immediately to savings = 85% remaining – which is your gross spendable income.
Example:
$100,000 gross annual income
First we save – 15% or more if possible. That’s $15,000 annually.
$85,000 remains.
25% of the $85,000 can be used to pay off debt. That’s $21,250 annually.
Debt means cumulative debt – both the types that allow you to acquire an asset that appreciates AND the depreciating chunk of metal in the driveway, meals consumed last week, or a trip next summer.
The remaining 75% of your spendable income will fund your lifestyle – including paying taxes, living expenses (both fixed and discretionary), Food, Utilities, transportation, education costs, protection documents (insurance) additional savings or retirement contributions. The sums add up fast so be careful. Taxes will take the largest share, especially if you live in a state where there is a State Tax as well as the Federal. Plan on at least 20%, for taxes alone, probably more depending on your income. Take small, methodical and intentional steps.
Since tax rates can change as incomes increase and laws change, it’s important to work with gross numbers when talking about income, savings and debt. Know that taxes will come out of your lifestyle money. You’ll maintain better control over taxes if you position them in your financial life as an expense that you DO have some control over – at least to the extent that you can implement strategies to minimize them from year to year.