In today’s world, taking on debt seems to be a matter of course. It’s how you’re expected, even encouraged, to pay for college, a new car, and a house. Even if you’re averse to getting into debt, the high costs of those things can make it necessary to take out loans. So is debt really a problem?
The Problem with Debt
Is taking on a little debt such a big deal? Let’s look at the numbers.
NerdWallet analyzed the US credit card and household debt in 2018 and found the average credit card balance per household with a credit card balance is $6,929. These households are paying huge interest rates on these balances, as much as 25% of their balance.
In addition to the interest payments on their debt, credit card balances show these households are spending more than they’re taking in. Unless these families learn to manage their income and expenses, they’ll likely be stuck in debt cycles for years.
And that’s not all the debt. The study also found households in the US who hold debt have an average balance of $135,768. This six figures debt total can include mortgages, student loans, credit card debt, and car loans. This is just an average — many families have much more.
If you’ve ever considered debt payments just a way of life, let’s examine some reasons it may be more dangerous than you think:
- If you carry credit card balances, you get into the habit of spending more than you make.
- You’re buying things now with your future earnings, assuming you’ll be bringing in a similar or higher income than you are currently. But future income is anything but guaranteed. You may not be able to work (or want to) or could lose your job in the future.
- Money arguments bring an added layer of tension to your relationships and even affect your health.
- You become even more dependent on your job since you have to make debt payments.
- Debt limits your ability to save. Because you’re making high-interest payments, you have less money to save for your future.
Can Taking on Debt Ever Be a Good Thing?
Many business owners and real estate investors are only able to start businesses because of the availability of loans to secure capital. And many students can’t afford college without loans.
In these cases, taking on debt for a specific goal (and a plan in place to earn enough money to pay it off) is likely a good idea.
However, while debt can be a helpful tool in specific instances like these, many Americans treat credit cards and student loans like free money, forgetting they’ll have to pay it back. When you take on debt for frivolous purchases that won’t give you the opportunity to earn income to pay it back, you’re playing with fire and putting your future earnings in hock.
If you’re in a situation where you must take on debt, take on as little as possible. And have a clear plan to pay it off quickly.
If you do need to take out a loan, ask yourself:
- Will taking on the debt help you complete college so you can get a higher-paying job?
- Will it allow you to purchase a rental home that will be cash-flow positive in six months?
- Can you use it to build a business that will make money in a year or two?
If the answer is yes, then taking on the debt is probably okay.
If, however, you’re taking on debt because you can’t wait to save up the money for a purchase or you have no clear idea how you’ll pay off your loan, then it’s probably not a good idea.
I’m carrying lots of debt now, what’s the best approach to paying it off?
Despite such considerations, many of us have found ourselves with large credit card balances or student loans to pay off. With large debt balances staring us in the face, how do we begin the process of getting debt free?
Popular personal finance radio personality Dave Ramsey has a severe aversion to any debt, even mortgages. In his book The Total Money Makeover, he details a seven-step program for paying off your debt:
- Create a $1000 emergency fund
- Pay off your debts least to greatest
- Create a full emergency fund (6 months or more)
- Contribute 15% to your retirement accounts
- Pay off your house
- Build wealth
While his plan may take years to complete, thousands of people have followed the debt-free steps successfully.
Should I stop contributing to retirement accounts while I’m paying off debt?
If you do get serious about paying off your credit card debt or student loans, should you temporarily stop retirement contributions while you’re doing so?
There are many opinions on the subject.
Some experts, such as Ramsey, advise you to stop your retirement contributions to put all of your money toward repaying your debt. But he also warns you must maintain a laser focus and pay off your debt in a few years or less. Then, with no obligations to others, you can play catch-up with your retirement accounts.
The only problem with that advice is it ignores a crucial investing principle–time.
If you delay retirement contributions, even by just a few years, you’re missing out on exponential growth over time. If you’re not sure you’ll be able to pay off your debt quickly, in a few months or years, you’re better off continuing to contribute to retirement (at the very least, the minimum required to get an employer match) while you pay off your debt.
Should I pay off my home mortgage?
What about home mortgages? Many Americans carry a home mortgage and mortgages in the last few years have carried low-interest rates.
While many argue that mortgages may provide a tax deduction if you itemize, the Tax Cuts and Jobs Act (TCJA) also needs to be considered. With an increased standard deduction and changes to mortgage interest deductions, you may no longer be itemizing. Make sure you understand how you will be impacted or talk with a financial professional for clarification.
Plus, remember you’re still paying interest — your hard earned money is going to someone else.
While cases can be made for both keeping and paying off your mortgage, there is one compelling argument for paying it off, especially before you retire: you’ll no longer have to make monthly payments. It can be a financial and a psychological boon to know you own your home.
Additionally, you have a guaranteed rate of return with your mortgage payments that you don’t have with your investments. Many investment experts predict a 6–8% return for US stocks over the next decade, so a guaranteed 4% return with no risk may look more appealing. Especially if it’s the only debt, you carry.
If you’re still on the fence about paying off your home mortgage, consider converting your 30-year mortgage to a 15-year. Or even making extra loan payments to your existing mortgage. You’ll save thousands in interest payments and shave years off your mortgage.
Final Thoughts on Carrying Debt
Eliminating credit card debt and other loan payments from your life allows you to stop making interest payments and save or invest the money that used to be servicing your debt. If a large portion of your take-home pay goes to debt payments (mortgage, credit card, and car payments), then you’ll be hard-pressed to save much for retirement.
Avoid taking on new debt and steer clear of co-signing on someone else’s loans. If you deem taking on debt necessary for business or education reasons, ensure you have a clear plan and timeline in place for paying it off. Then you can keep more of your money and have more power and choice for your future.