This post is from a new FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog Out Of Your Rut.
Mortgages and student loans are regarded as good debt since they afford us the ability to increase our wealth and employment value in the world. Bad debt includes credit cards and consumer installment loans, and floating somewhere in the middle are auto loans—perhaps defined as good or bad based mostly by their size.
Why Good Debt may not be as good as we like to think
We have little trouble seeing the problems with bad debt, but let’s take a closer look at the debts we might call good.
Mortgages. The major positive aspect of mortgage debt is that it’s used to purchase shelter, which is a necessity. It’s also debt used to acquire what has been, at least until the past few years, an appreciating asset—a classic win-win.
But while the real estate/mortgage crisis of the past three years has been summarily dismissed as a temporary blip in a longer trend toward ever higher home values, it’s also exposed substantial weaknesses in the previously unassailable notion of mortgages as good debt. Consider the following:
- A mortgage is often a catalyst for other debt. Buying a home usually sets off a chain of spending in other directions—home furnishings, remodeling/rehabbing, a new car to go in the new driveway among them. Already cash strapped new homeowners commonly borrow to pay for these.
- The enormous size of mortgages in relation to income and to other debts can make early payoff seem impossible, fueling a pattern of perpetual debt.
- People often respond to rising home values and increasing equity by periodically borrowing much of it out, creating a debt treadmill.
- Because of the many virtues attached to owning a home, buyers are often tempted and encouraged to buy more house than they can afford. This is one of the major reasons for the mortgage meltdown.
- Low down payments cause buyers to over-rely on mortgage financing. In this way, future income has been fully and entirely committed to an extreme degree years before it’s even earned. The result is often a pattern of never getting out from under.
So is a mortgage a bad thing to have? No. And yes.
It can be good to have if you…
- can make a down payment of at least 20% of the purchase price,
- buy beneath your means—your house payment is no more than 20-25% of your stable monthly income,
- have the desire and the means to pay off the loan in substantially less than the original term,
- have some breathing room in both your monthly budget and bank account after closing, and
- buy a house as a place to live long term, not as an investment to be flipped at an expected profit in five years or less.
A mortgage is a bad thing if it represents nearly the entire purchase price of the home, if it will leave you with an empty bank account, if it will consume so much of your income that you’ll have little money for anything else, if you have no ability or intention to pay it off early or if your primary reason for buying is for investment potential.
The fact that a house is a good thing to own, and that a mortgage is needed to buy it, should never mean that we abandon good sense in the process.
Student Loans. So much virtue is attached to a college education that debt incurred to attain it is often considered only in the most benign terms. Fueling this view is that fact that student loans carry repayment deferral, government guaranteed below market interest rates and impossibly small monthly payments. Student loans may be the “good-est” of good loans!
For that reason alone, red lights should be flashing while emergency sirens scream.
Even with a 4-5% interest rate and a monthly repayment equal to no more than 1% of the outstanding loan balance, repayment on a loan of $40,000, $50,000, or $100,000 is still prohibitive, both in the size and duration of the payments.
Imagine having a $50,000 loan with a $500 per month payment that you’ll have to pay for ten years or more? And you will pay it. A government backed student loan usually cannot be discharged in bankruptcy, and if you fail to pay, your resources—including income tax refunds—can be seized until the debt is satisfied.
You will be required to pay the loan at a time in your life when you will be on the low end of the income scale, when you may experience a slip or two on the way up the earning curve, when you may be considering marriage, children or a geographic move, and when you will be acquiring necessary life’s assets such as a home and car.
In my many years in the mortgage business, I can’t count the number of times I saw loan applications from people in their 20s and early 30s who had a financial profile that looked something like this:
A $10,000 car loan
$7500 in credit card debts
$50,000 in student loans
A $35,000 salary
A $3000 bank account
This person is carrying $67,500 in total debt on an income of just $35,000! Even if he had the potential to double his income to $70,000 in five years, that would still be an enormous debt load. But even by the time his income reaches that level, he’ll likely also have commensurately more debt. After all, he’s already applying for a mortgage! A wedding and children will only increase the pressure to borrow.
One of the biggest hidden land mines with student loans is the fact that they put the borrower in a deep debt hole early in life, which can set a pattern that follows throughout life and is difficult to overcome.
Good or bad, ultimately it’s all just debt
One of the problems with debt in general, is the perpetual nature of it. Any time we borrow money for any purpose, a dynamic process is set in motion. Once that process is in operation, reversing it to pursue a different course is considerably more difficult.
What ever label we chose to put on it, good, bad or in between, all debt shares the same characteristics:
- it represents an obligation which must be paid back
- it represents a lien on-, and therefore a reduction in-, our income
- it lowers our net worth
- it limits our mobility and constrains our options
When you consider these facts, do you truly believe there is such a thing as good debt?
Photo courtesy bluemodern
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