Last Updated on August 14, 2020
Debt is one of those things that seems like a relatively simple concept. That is, right until you get into all the nitty-gritty details of it. Most of us understand that debt is generally a bad thing. However, there’s also a case to be made for certain types of debt being classified as ‘good’ debt. Setting aside the argument of whether ‘good’ debt or ‘bad’ debt exists, what most of us may not be as familiar with is the various ways in which debt can infiltrate other aspects of your finances and cause some unintended but far-reaching consequences.
What is debt?
Debt is incurred when one party (the debtor) borrows money from another party (the creditor). Typically this involves an agreed-upon date and structure of repayment. The creditor also dictates in the agreement if and how much interest will be charged for lending the money.
One example of debt is credit card debt – and that’s one many of us are familiar with. In fact, the average credit card debt per American borrower was $5,554 in 2019. When we swipe a credit card for a purchase, we are the debtor, and the credit card company is the creditor. The credit card company pays for the purchase right away and adds the purchase price to a tally of what we (the debtor) will owe them when our monthly statement comes due.
In simplified terms, if you pay your credit card balance in full each month, then no real debt is incurred. This process more so mimics a delayed payment structure. However, if you carry a balance, you are then subject to the credit card company’s debt policies regarding minimum payments, interest charges, as well as late payment penalties.
Another example of debt is an auto loan. In 2019, debt incurred via automobile loans accounted for 9.5% of all US consumer debt. When most of us purchase a vehicle, whether new or used, we find it necessary to borrow a certain amount of money to pay for the car. When we incur that debt, we make an agreement with the financing party to pay back the borrowed money on the agreed-upon schedule, with (sometimes 0% if you’re lucky!) interest.
Is there such a thing as good debt?
If you google this very question, “Is there such a thing as good debt?” you’ll find a LOT of strong opinions on both sides of the aisle. Emotions aside, debt is debt. Anytime that you have debt, you owe someone money. Owing someone money is not a feeling most of us enjoy. But, if we’re being realistic, taking on debt allows us to make investments in ourselves and our lives that we would not likely be able to do otherwise.
Few of us can buy a car or home, or pay for college outright. So the important question is not necessarily whether or not the debt is good or bad. The important question is whether or not the purchase is worth taking on debt.
So, is it smart to take on a huge loan to buy a Lamborghini? Doubtful. Is it smart to take out a loan to go to college? If the degree you pursue will likely land you a job and salary that provides you with a good return on investment, then yes – that’s probably a smart move.
6 important reasons why debt is (generally) bad
Regardless of why you incur debt, here are the important things you need to know about why debt is bad and how debt ultimately impacts your financial health.
1. Debt costs money (most of the time)
Debt can be expensive. Unless you are paying 0% interest on your debt (which is not very common outside of automobile financing and borrowing from Mom and Dad), then it’s important to remember that taking on debt costs you money. The higher the interest rate and the longer the debt repayment, the more you’ll end up paying for your debt.
For example, the average credit card interest rate is 18.61%. If you are carrying a $5,000 balance on your credit card, and only paying $500 per month at 18.61% interest, you’ll ultimately pay an additional $429 in interest. And that’s if you don’t add anything above and beyond a $5000 carrying balance to your credit card in that time period. The higher your carrying balance and the lower your monthly payment (i.e. the longer you take to pay off the balance) the more you’ll pay in interest.
2. Debt incentivizes spending more than you have
Taking on debt, especially via credit cards, can sometimes happen a little too easily. When you’re dealing with cash, you either have it or you don’t have it. On the other hand, with a credit card you have the ability to charge expenses up to your monthly limit regardless of whether or not you actually have the funds to pay for whatever you just bought.
3. Debt limits your ability to save and invest for the future
Because debt can be expensive, it limits your ability to save for the future. Debt basically allows you to pay for a current product or service with future dollars. It is a retroactive approach to spending money.
However, healthy personal finance habits need to be forward-looking. In order to be able to cover your bills as well as save for the future, it’s much better to frame your finance habits by paying yourself first. It’s important to limit the number of current products and services you pay for with future dollars, and instead pay your future self (via saving and investing) with current dollars.
4. Debt can prevent you from owning a home
When you apply for a mortgage, the lender will consider all of the debt you currently hold, including credit card, auto, and student loans. Having a lot of debt may prohibit you from getting a good interest rate. That means that the debt you are already paying for will cost you even more money in the form of the debt you’ll incur to buy a home.
In the worst-case scenario, having too much debt will likely cause you to be denied for a home loan altogether. Most lenders will not qualify someone for a mortgage if their outstanding debt adds up to 43% or more of their annual income.
5. Debt can decrease your credit score
Your credit score is incredibly important when it comes to accessing lines of credit, loans, and their corresponding interest rates. A credit score is essentially a signal to lenders letting them know how likely you are to repay your debts on time.
How much debt you owe is one of the largest contributors to your credit score. Your debt ratio (how much debt you have compared to your income) accounts for 30% of your credit score. Thus, the more debt you have, the less attractive of a borrower you will seem to creditors. The less attractive of a borrower you seem, the less attractive offers you’ll be able to take advantage of for things like reward credit cards, lower interest rate loans, etc.
Debt is expensive. If this is sounding a bit like a broken record, you’re right. But it’s important to realize just how expensive it can be. Debt is expensive in and of itself. But the more debt you have, the more expensive it becomes. It can very easily create a positive feedback loop of higher and higher interest rates, fees, and penalties.
For example, if you have significant credit card debt, it will likely drop your credit score. Having a lower credit score will lessen your trustworthiness in the eyes of a lender. That means that if you were to try to acquire an auto loan or mortgage, the lender may be wary of approving you for funding. If they do approve you, it will likely come with higher interest rates to offset the risk you pose to them as an unattractive borrower. Having debt causes any additional debt to become even more expensive.
6. Debt causes stress
Outside of the financial costs of debt, it’s important to account for the personal costs. Being in debt is stressful in and of itself. But it can also put a serious strain on the people you choose to spend your life with. It limits your options, can cause arguments, and forces more of your precious time to be put towards figuring out your financial future.
What can you do about reducing your debt and debt-incurring habits?
It is important to reiterate at this point that not all debt is ‘bad’. However, it is absolutely essential to determine what purchases are worth going into debt for. In order for you to help determine that, here are three essential questions to ask yourself:
– If you had to pay in cash, would you still buy it?
– What is the total cost for this item if I incur debt to pay for it? Ensure you include the interest you’ll be charged. Don’t get caught up in determining what you can afford in a monthly payment. Monthly payments can vary widely and don’t make obvious the amount you’ll ultimately pay for the product versus the interest on the loan.
– Is this purchase worth it for your present way of life or would it be better to use that money for your future?