Debt: Creator or Destructor of Wealth?

“It is the debtor that is ruined by hard times.”
—Rutherford B. Hayes

We believe that debt is a tool and, if used properly, it can help build wealth, facilitate transactions, and pay for things we need, like cars and college.  If it is used incorrectly, it can spiral one’s financial situation into bankruptcy or even poverty.  Debt is a powerful financial tool, and it is important to remember that it comes with an obligation to repay it along with interest.  

Types of debt

Generally, the cost (interest and fees) of borrowing is determined by whether the debt itself is secured or unsecured.  Your mortgage is “secured” by your house.  If you were to default the bank could take possession of your house and sell it to recoup their loan. 

A home equity loan or line is also secured by your house and is often in 2nd position IF you also have a 1st mortgage.  If you don’t have a first mortgage, then the equity line/loan is in 1st position.  An auto loan is also a secured debt with the car as the collateral.

Secured loans usually come with lower interest rates because they are deemed less “risky” by the lender.  Unsecured debt is riskier because there is no collateral for the lender to rely on in the event the borrower doesn’t make their payments. For example, in 2022, unsecured credit card debt comes with an average interest rate of 19%.

Repayment of loans, particularly consumer debt, is either revolving or by installment.  Installment debt is usually a fixed payment that includes principal and interest.  The loan is dispersed in full, think car loan.  The dealer is paid in full by the lender and the borrower makes installment payments.   An exception would be student debt which comes with various repayment plans.   

On the other hand, revolving debt means the line of credit can be drawn down as needed and paid in full or with a partial payment.  Once repaid, the credit is available to be used again.​

America has a crazy love affair with debt.  More than 75% of Americans have debt of some kind.  According to Dave Ramsey, 8 out of 10 Americans have at least one credit card and 45% of those folks don’t pay their balance each month and, therefore, carry credit card debt.  Yowza!
  
And to make debt even more problematic, we have BNPL (buy now, pay later) options for almost everything we purchase online.  BNPL apps (Klarna, Affirm, Sezzle, Paypal, Zip, etc.) allow consumers to make their purchases and pay in equal installments, usually for zero or little interest. 

​However, do not be fooled.  It inherently builds bad consumer behavior by encouraging people (usually young) to become accustomed to immediate gratification (focusing on their wants, not needs) and fooling themselves into believing their cash flow is intact.  Installment debt can add up quickly and create ugly default scenarios.

How much debt is too much debt?

According to Investopedia a good way to calculate your debt load is to use the 28/36 Rule.  The 28/36 rule states that no more than 28% of a household's gross income should be spent on housing and no more than 36% on housing plus debt service, such as credit card payments, student loans, auto loans/leases, etc.  At 43% debt to income, lenders become uncomfortable, and beyond that it gets harder to qualify for additional loan products. 

The big risks to carrying too much debt include:
 
Compounding

• The rate at which the interest compounds is a huge risk.  While we love compounding when talking about building wealth, savings, and investments, we hate it when it comes to compounding interest rates on debt.  It can easily destroy wealth if it is not managed properly.  This article by debt.org is a great primer on compounding debt.  

Risk to Credit Scores

• In our previous blog we talked about the impact of repayment, credit utilization, amount of debt, and types of debt to credit scoring.  Too much debt will adversely affect credit scores, which may in turn have an impact on other facets of life including employment.  According to the National Association of Background Screeners, 95% of employers conduct some kind of background screening on future employees.  Industries that specialize in banking, finance, and investing generally pull a modified credit check.  Red flags include:
• A lot of late payments could indicate you’re not very organized and responsible, or don’t live up to agreements.
• Using a lot of available credit or having excessive debt are markers of financial distress, which may be viewed as increasing the likelihood of theft or fraud.

Cash Flow Risk

• Cash flow is king.  The ability to obtain credit is based on a borrower’s ability to repay the debt.  It isn’t unusual for a dual income couple to apply for a mortgage using both incomes.  What happens if one of them loses their job?  How long can their cash flow sustain their current debt load without resorting to dipping into savings (emergency funds) or, even worse, tapping into their retirement funds?

Opportunity Cost

• While borrowing can help build wealth, at some point it can also become an opportunity cost and deterrent to building wealth.  The opportunity cost is the ability to invest (for the long term) the dollars going to interest and repayment.  
• For retirees, debt can “choke” what would otherwise be a carefree and less expensive lifestyle.  Our retiree clients without debt truly feel they have more financial freedom and less stress than those who continue to carry debt.

When is the Right Time to Pay Down/Off Debt?

Our best advice is to create a financial plan and experiment with different scenarios.  That is what we do for our clients.  It requires some homework, like gathering expenses, projecting future income, and making sure your partner is on the same page.  Every household is different, but it is an important exercise to complete to make the most of your money.

For further information please contact Jenifer@mosaicfi.com

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