At present the US household debt stands a little over $12.8 trillion; a pretty staggering number in my opinion. That amounts to $51,000 of debt for every adult in the US; ouch. Bear in mind that household debt is consumer debt; it has nothing to do with the US Government debt. As you can see US consumers owe quite a bit of money, which begs the question is debt a bad thing? Is debt something that should be avoided at all times; can it even be avoided? There is no universal answer, but the questions do warrant a discussion. Obviously too much debt is not good, and the wrong type of debt is not good either, but there is more to it than that. In this post we will discuss:
- Different types of consumer debt
- Good and bad debt
- How much debt is acceptable
- Whether debt is necessary
Consumer Debt
In simple terms consumer debt is debt owed by consumers as opposed to businesses or governments. To be more specific consumer debt is debt as a result of purchasing goods that are consumable and/or do not appreciate. Consumer debt consists of:
- Mortgages (loans specifically for the purchase of a home)
- Car and related loans (boats, jet skis, RVs, etc.)
- Student loans
- Credit card debt
Houses are considered consumer goods, so they fall under consumer debt. Consumer debt can help fuel economic activity, but too much can be risky to the economy and the consumer both. Consumer debt has recently surpassed the level it reached in 2008 right before the economic recession occurred, and some finance professionals are concerned that the rising debt will result in more defaults in the near future.
What does all this mean? First off, I am not trying to sound any alarms or scare folks. You and I cannot do much to decrease the overall consumer debt; however we can take steps to manage our own personal consumer debt. Ensuring the debt you take on is reasonable and prudent will keep you financially safe and secure.
Debt: Good or Bad?
Many financial professionals say debt itself is not necessarily a bad thing, but some other financial experts say debt is never good. I am of the opinion that debt is not a bad thing if good judgment and a solid plan is used to acquire the debt. The main problem with debt is that if you get in over your head it can bury you. Taking on too much debt can result in poor credit ratings, repossession of property, housing foreclosure, and worse case bankruptcy. A military specific issue is too much debt can result in suspended or revoked security clearance. How much debt you take on will largely determine if it is good or bad.
Now, different types of debt can be better or worse than others. It goes without saying that credit card debt is bad because of the very high interest rates. When I say credit card debt I am talking about carrying a balance from month to month. If you are a person that pays off your balance in full every month then you are not in credit card debt (and good on you for doing that).
Car loans are generally a bad debt. Cars are a depreciating asset, and using debt to buy a depreciating asset is normally not wise. Some finance experts will say never take a car loan and that if you need a loan then you should not be buying that car. Others don’t see car loans as a bad idea provided the loan and the car being purchased are reasonable. Amy and I have both paid for cars with cash and taken out loans to buy them. I will be discussing car buying in future posts, but my current line of thinking is the best approach is to pay for a good used car with cash. Now, I fully realize that may not be possible so I recommend using good judgment and have a solid plan when considering taking out a car loan.
An example of good, or at least acceptable, debt is a mortgage. In general homes appreciate in value over time, so taking on debt to purchase an asset (a home) that increases in value is not a bad thing to do. Word of warning though: buying too much house can land you in trouble. A reasonable mortgage used to purchase a reasonable home can be considered a good debt.
Student loans can be considered a good debt because you are investing in yourself. I know some of you are probably shaking your heads right now given the very high student loan rates at present, but hear me out. Hopefully the goal of obtaining more education is to increase your overall earning potential. By increasing you earning potential you are essentially investing in an asset (yourself) that appreciates in value. Statistics support the fact that normally the more education you have the more earning potential you have and your unemployment rate is less.
How much Debt is OK?
At this point you may be wondering how much debt is reasonable. The short answer is total debt should be kept at or below 30-35% of your gross income. The long answer is that it can vary depending on who you are and where you are at in your life as far as career, spending habits, obligations and so on. In general terms you want to keep your total housing expenses (mortgage payments, taxes, insurance, etc.) less than 25% of your gross income and your other debts less than 10% of your gross income. As an example when Amy and I were looking to buy a house in 2005 our bank wanted our mortgage payment to be a max of 30% of our gross income. This set a limit on how expensive of a house we could purchase, which was actually a good thing. Thanks to the bank setting a limit we did not become house poor.
Debt: Necessary or Not?
For most of us debt is necessary at some point in our lives, and that is not something to feel ashamed of. How many people can buy a house for cash or pay for all of their college expenses? I know I needed to take out student loans for some of my college costs even though I worked a job all through school. Amy and I also needed a mortgage to buy our first house.
On the other hand is it necessary to take out a $40,000 loan to buy a nice new truck? No, it sure isn’t. Remember the needs versus wants categories when considering whether or not to take on new debts, and of course don’t get in over your head with debt.
Key Takeaway and Conclusion
If you are only going to take one thing away from today’s article is should be this: don’t get in over your head with debt! I have heard several of my friends say that quitting smoking/dipping is so much more difficult than never starting in the first place; debt is the same way. It is much easier and less stressful to avoid having too much debt than it is to get out of a debt hole. I encourage you to make informed and mature decisions when it comes to taking on debt. If you want to reduce or eliminate debt then take a look here.
Sources
https://www.newyorkfed.org/microeconomics/hhdc.html
https://www.census.gov/quickfacts/fact/table/US#viewtop
https://www.bls.gov/emp/ep_chart_001.htm
http://www.investopedia.com/ask/answers/12/reasonable-amount-of-debt.asp
https://www.federalreserve.gov/releases/g19/current/default.htm
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