84: Adulting 101 Series: Debt

We hear it all the time: “I feel like I’m not actually an adult because I have debt. And debt is bad!” Do you resonate with that? Well… we’re here to tell you a few things about debt that just might blow your freakin’ mind. Check out the fourth installment of our #Adulting 101 series about *drum roll please* debt repayment. How much should you be paying to debt? You’ll probably be surprised.

WHAT YOU’LL LEARN

02:19 What people sacrifice for the sake of paying down debt

03:20Generational fear and hatred of debt

03:46 Dustin’s chart that “explains everything”

05:00 Why the truth is that not all debt is bad — and why not all debt should be treated equally.

07:42 Why you should treat interest rates like a game

08:26 The definition of interest 

09:09 The good, the bad, the ugly debt

10:56 At what percentage you should start focusing your debt repayment

11:26 What Dustin thinks is “horrifying”

12:58 How much should we be paying off our debt?

13:29 How to shift your savings goals around to pay off high interest debt

14:10 Why debt should be viewed as a tool that gives you leverage

16:29 How paying down debt can actually risk your long-term wealth

17:40 Why you may be risking stability in a recession

IT’S NOT THE 80’S ANYMORE, MOM

Do you have parents, grandparents, or older family members/peers in your life who talk about “debt being dumb”? Maybe you’ve heard a shall-not-be-named “money guru” say that and thought, “Well crap, I must be dumb.” We take issue with this approach to debt. Why? Because it’s the not the same world anymore, and sometimes debt is kinda smart. Yeah, we said it.

From the early 70s all the way up until the financial crisis in 2008, there was about 40 years of high interest rates. These interest rates were way higher than historical averages — and even what we’re looking with now. That means, if you’re a Millennial, your parents were maybe paying 14% interest on their mortgage. Insane right?! What’s even crazier is that today, we’re looking at the lowest interest rates in over 200 years. So, when we talk about debt “back then” and debt nowadays, we’re talking about apples and oranges.

This means that owning a house with a 4% mortgage is wayyyyyy better than owning one like your parents did (and probably paid off) at 14%. This means that your car loan at 4 or 5% is wayyyyy more affordable than your dad’s old T-Bird. And you know what? The cost of college has increased 260% since 1980. So thanks, Aunt Linda, for the story about how you paid your way through college, but the reality is we need loans to get that same education.

So, when we talk about debt, know that we (as in Dustin and Danielle) know that we’re actually talking about interest rates. And as Danielle puts it, interest rates are really just a game you gotta play. 

HOW TO PLAY THE INTEREST GAME

To put it simply, interest is the cost of acquiring money. How much does it cost to borrow the money you need? How much will it cost you to take out a loan to buy a house? How much does it cost to get money to pay for your education? And is the interest worth that cost to you? Really, that’s a good measurement of your need for debt. Do you want to pay 7% extra for that car… or would you be cool with paying 7% on a cheaper car that still gets you where you wanna go?

And interest has another important role in your debt: it helps you decide which debt is “good,” “bad,” and “ugly.”

THE GOOD, BAD, UGLY DEBT

We’re not telling you to ignore your debt if you have, let’s say, a 0% interest rate on your new car or home furniture. What we are saying is that you shouldn’t push yourself to the brink to pay down debt that has a low interest rate. But yeah, sometimes we make mistakes and go into credit card debt over stupid crap like a new phone and some killer blue suede shoes. Those are the kinds of debt that we want to avoid — and pay off faster. Other times, things like predatory lending can get us in a bind and we may be paying 20-30% on things like cars, payday loans, and credit cards. So that leads us into the good, the bad, and the ugly — which we talk about in depth on Episode 60.

But the gist is this:

“Good” debt (and yes, we use that term loosely) include: 

• Mortgage
• Auto loan
• Student loan
• Business credit cards or loans (with good interest rates)

These are used to improve your situation.

“Bad” debt:

• Adjustable rate mortgage (you buy a house and the rate can be changed over time, sometimes ridiculously high)
• High interest student loans (that you’re just paying the minimums on)
• High interest car loans (this happens if you have bad or no credit)

A good frame of reference for bad debt: anything higher than 5%. If that’s where you’re at with a loan, it might be good to buckle down and pay more.

“Ugly” debt:

• Credit card debt
• Store credit debt
• Payday loans 

 

“Ugly” debt usually is qualified by interest rates in the 20-30% range, and they require you to really do some work to get them paid down. Why? Because you’re paying up to a third more than you spent — that “cost” associated with the money is totally not worth it. 

But, now that you know which debt you should be prioritizing, how much more should you be paying to your good/bad/ugly debt?

HOW MUCH SHOULD WE BE PAYING TOWARDS DEBT?

This doesn’t apply to every person, but a good rule of thumb is to spend about 5-15% of your income on debt. This includes your credit cards, your student loans, your car payment, etc. It does not include your mortgage, which is part of our housing episode (jump to Episode 81 here). 

And, again, it depends on the interest rate! Are you at a smaller interest rate like 4%, or high percent like more than 17%? If you’re at 6% or higher, you should probably lean more towards the 15% of your income range going to debt repayment. But not at the cost of your savings!

Remember your savings and investing. You should be saving (and giving) about 25% of your income but, if you have a lot of high interest debt, you might want to cut back on that investing if your interest is high. Then, once those higher interest debts are paid off, you can ramp up the savings and pay down the other lower interest rate debts over time. Why do we say this?

 

Because investing can net you 3-6% on average… which negates any sort of interest you’ll be spending on low interest debt.

 

How? Because as you compound interest on your savings and investments — meaning you grow your accounts because you’re getting paid interest into them — you continue to add more money, and get paid interest on those higher amounts. You’re making money on the money you’ve earned. It’s freakin’ magical. You know what’s not magical? Going broke to pay off low-interest debt.

DEBT ISN’T YOUR RISK; IT’S THE FINANCIAL INSTITUTION’S

We’d like to leave you with one last note: People think all debt is bad because it’s a financial “burden” that rests on them. But that’s not the truth. The party carrying the real burden are the banks that loan us the money. Essentially, you could never pay that money back (sure, you’d be screwed, but they’d be out the money), so they are the ones more at risk than you are.

We hear this all the time when we see Facebook rants about how “China owns our debt!” What you need to understand is: we don’t have to pay back that debt right now. We have more money in our bank account because they (China or the banks) are holding that debt for us. This frees up more cash in our accounts to pay them back, but also still keep living.

And there’s psychological value in knowing that we can pay things back over time — making it possible for us to do other things in life, like buy a house, have a baby, build a business, etc. We’re not saying don’t pay down your debt, or to only ever pay the minimums. But we are saying that you can do it at a pace that allows you to fill your other buckets. 

DON’T PAY DOWN DEBT AT THE RISK OF YOUR OTHER NEEDS

We’re just gonna say it: having an emergency fund so you don’t have to go into credit card debt in case of an emergency is much more important than just paying off your credit card right now. Being able to afford the roof over your head while also paying down your student loan debt is more important than going all in to pay down your debt — and losing your roof in the process. And building long-term wealth is more important than paying down “good debt” for the sake of saying you are debt-free. #JustSayin

The biggest advantage of being young is that you can save so much, and therefore gain so much compound interest, that you can build vast amounts of wealth over time. But if you’re focused on paying back “good” low interest debt, you’re losing out on those prime saving years — and setting yourself up for more risk if something not-so-fun happens.

So let’s reframe your debt: low-interest debt can give you power and leverage, rather than be a burden. It’s not 1985 anymore, so don’t let older generations tell you all debt is bad. Instead, lay out your debt, look at the interest rates, and figure out which debt gives you power and which debt is taking AWAY your power. 

 

This material is for general information only and is not intended to provide specific advice or recommendations for any individual.

 

RESOURCES & PEOPLE MENTIONED

• Ep. 81: Adulting 101 Series: Housing: Episode 081
• The Toujours Planning Quiz — Are we a good fit for your financial planning needs?
• Our FREE go-to financial and life planning resources

 

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