The prevalence of debt is in nearly every aspect of our lives, from credit cards to auto loans, home mortgages, student loans, and the list goes on and on. As a nation of consumers, we are masters at spending money, which can include spending money that we don’t have.
Advisors are often asked about good versus bad debt. Perhaps a more accurate way of looking at that question is to help determine more constructive uses of one form of debt over another. While the comfort level of having debt will vary from person to person, it is difficult to dispute that debt can be a powerful financial tool. Like most things, when used in moderation, debt isn’t necessarily bad. However, when abused, it can be a different story.
There are basically two forms of debt: secured and unsecured.
Secured debt, also known as collateralized loans, is backed by an asset such as a house or car. These are loans that are given to people with the promise of repayment or repossession of the asset if the loan terms are not met.
Conversely, unsecured debt (noncollateralized loans) refers to debt like credit cards, personal loans, payday loans and medical repayment plans. These loans are based on the creditworthiness of the person’s ability to pay back money borrowed over time.
Too much of a good thing can be harmful, not only from a financial point of view but also psychologically. To illustrate a better picture of this, consider the following example:
For background, this person earned a decent salary and qualified for a conventional mortgage loan. The allure of travel was evident in their spending choices and in the number of travel credit cards and their debt load. I could tell that they had attempted to improve their financial condition by rolling high-interest debt into a lower interest rate home equity line of credit, but unfortunately, debt creep and rising balances were beginning to cause a fair bit of stress and concern. The debt service was about one-half of this person’s pre-tax income (including mortgage payment), and because of the cycle of using a credit card to make the monthly payment of another credit card, high-interest debt was accumulating fast. We talked about one of two ways of paying down the debt. Each has its benefits and drawbacks, but both achieve the same result, which is to pay off the debt in meaningful steps.
Stair-step approach (snowball method)
The technique used for this person was a stair-step approach, also known as the snowball method. Here is how it works: Using a spreadsheet, we plotted each loan in the order in which the balances would be paid off. Since there was no room within the monthly budget for extra payments, we tackled the loan that would be paid off the soonest. When this balance was paid off, we took the monthly payment from that loan and added it to the second loan’s monthly payment, sort of like doubling up the monthly payment. When the second loan was paid off, we took that payment and applied it to the third loan’s monthly payment and so on until all eight creditors were paid off.
Mathematically, this person would have been better off if we used a different strategy. The alternative approach looks much like the above. The difference, however, is to focus on paying off the balance with the highest interest rate first. Once paid off, take the loan payment and add it to the monthly payment of the debt with the second-highest interest rate, and so on. This is referred to as the avalanche method and will typically pay off debt faster than the snowball method.
Readers may be wondering why we used the snowball method. Easy: the psychology of debt. Getting that far in debt took time and came with a healthy amount of instant gratification. For some, going cold turkey will cause more harm than good as the borrower will be judicious in making timely payments at first but, with no gratification, will revert to old habits. That is why, with the snowball method, I recommend a reasonable, yet meaningful, reward each time a loan is paid off. This can take on many forms, but I typically recommend nonconsumable objects, such as clothing, small electronics, décor items or something equally tangible. This will aid in satisfying the gratification urge while also paying off the debt in meaningful steps.
Understand that this is not an exhaustive list of good versus bad debt or benefits versus drawbacks. In bigger-picture terms, borrowing money is not necessarily inherently good or bad — rather, some forms of debt are generally considered more constructive than others. Borrowers should consider whether they would be better off saving up and paying cash for an item, saving enough money to use as a down payment and limiting the amount of money borrowed, or financing the whole purchase. Which is better? It depends on a lot of variables that include income, taxes, personal living expenses, current debt load, financing expense, need versus want, personal attitude toward debt, and others. Know that you are not alone in your decision; your Parsec advisor is going to be a great resource for you to bounce questions off and will also speak objectively with you regarding your decision.