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As a career and life coach, I often talk to people about why they work and for many people it is about paying their bills. Our career and life coaching conversations often migrate into financial coaching which is why I am in the process of becoming a certified coach with You Need A Budget (aka YNAB - pronounced why-nab). The YNAB software has been a real lifeline for me in getting my finances in order and keeping them there. But software is only one small piece of a much larger piece of learning about personal finance. One of the biggest pieces is how to use debt responsibly. In this article, I want to talk about how to use debt responsibly.
Not All Debt is Bad
The vast majority of us will find ourselves in debt to another person or organization at some point in our lives. From the simple - "I forgot my wallet today - can you spot me $20 for lunch and I'll pay you back tomorrow?" to the complexity of credit cards, mortgage, student loan and medical debt - we all finding ourselves needing to put someone else's money to use for us from time to time.
The challenge is learning what debt is "bad" and what debt is "good."
I have long considered mortgage debt and student loan debt - both within appropriate limits - to be good debts to take on. Obviously, if you have the means and capability to avoid them entirely then please do so. However, if you can't avoid debt, then you need to think about the limits to your debt.
I went into my college education with the belief I would be a high school teacher for the rest of my life. Through scholarships, prudent choices about colleges (going to a state school), and my mom taking on an additional job to help make sure I didn't have debt, I was able to graduate from my undergraduate education without debt. However, my choice of majors drastically limited the choices I had in schools if I wanted to make sure I graduated debt free with the scholarships I had and my parent's ability to pay.
Let's look at my situation in today's numbers. According to U.S. News and World Report, the median high school teacher salary in 2021 was $61,820. Starting salaries are about $50,000. According to a July 2021 report from the National Education Association, 45% of educators were student loan borrowers and over half of those still had a balance. Balances averaged almost $59,000. While that may include Masters education for some, with many schools and states no longer rewarding the masters degree as they once did, the value and debt of the degree is really in the hands of the teacher and not the school district. So, taking on more than $50,000 in debt for a job that will pay, at best, $80 - $90K a year after a decade of experience is not likely the best choice for a life of financial freedom.
P.S. - If you're wondering how to figure out what amount of debt is "too much" when you're making college and job decisions - the best rule is to keep your borrowing for college under the amount of the likely starting salary for the position you're considering. I also think it's a good idea to run the amount you expect to borrow through a repayment calculator and see if you'd be comfortable paying the minimum monthly due on what you plan to borrow against your expected starting salary. Make an actual budget for yourself including mortgage/rent, car payment, etc. These are all semi-known amounts that you can figure out what a reasonable google search. Taking a couple of hours to dig into a potential budget before you make a borrowing decision could save you years of headaches in the future.
Mortgage debt is similar. I see so many people who are house poor. They bought a house with a mortgage at the maximum amount the bank approved them for and then they struggle to enjoy life because all of their cash is tied up in their house. While every family has different needs, I bought a house that fit into my budget rather than a house the bank said I could afford. Those were two very, very different numbers - almost $1,000 a month different at the time I purchased my house.
So, our first rule of thumb on good debt is - is it debt that you can take on which still lets you live the rest of your life.
The second rule of thumb on good debt is the interest rate. Try to NEVER taken on any debt that has an interest rate over the current average market rate of return. Depending on what site you consult this is somewhere between 6 and 10%. I tend towards the conservative end of that so I try never to take on debt that has an interest rate over 6%.
What does that mean in practice?
If I have 200 dollars to spend on an investment, I can generally expect that I'll make a 6% return on that investment in a year (although that was definitely not the case in 2022). If I borrow at a lower than 6% rate of interest then I'm borrowing at a rate lower than what I can make on money I might invest. I'm still paying someone else to use their money but it's at a rate that is reasonable and helps make my decision to borrow simpler because the rate seems fair.
A note on mortgage interest in 2023 - As I write this, mortgage rates for home loans are all over 6%. Yet, sometimes you have no choice but to sell a house and move to a new one in times like these. If that's you, then your to do list needs to include watching for the best opportunity to refinance that loan when rates go down and to make sure that if rates don't go down you can still afford that payment in your budget.
Use Credit Cards As Budget Tools, Not Spending Tools
I had to learn this one the hardest way possible - by pulling myself out of thousands of dollars of credit card debt.
Credit card purchases should be made against an actual budgeted amount of money that you have in your account. Credit cards are not spending tools. Putting something on a credit card that you don't have an actual plan to pay for is ill advised.
That said, credit cards are a valuable way to earn rewards that allow you to do things like travel and earn cash to increase your wealth.
Most credit cards, with APRs of 13% and up, immediately break the "good debt" rule of thumb of an interest rate between 6 and 10%. However, credit cards, when treated as a part of the monthly budget and used to buy things you would have purchased within your budget anyway, are a great resource for increasing your ability to travel.
I use my primary credit card for all major purchases for my personal life. With that credit card, I've also amassed enough points to allow me to make plane trips, upgrade to business class on long flights, and book entire weeklong hotel stays. My credit card also provides purchase protection and travel insurance on certain purchases meaning I have extra safety against unforeseen circumstances.
My credit card purchases get budgeted every month just like my checking account purchases do.
If using a credit card in this way is a problem for you - as it was for me for many parts of my life - try not carrying the card with you for a while or try putting purchases on a wish list first and then purchasing off of your wish list only after a few days have gone by. Especially in the world of online shopping, this has been a true game changer for me. I won't forget the item - it's safely on a digital wish list - but I also don't have to buy it when I haven't yet budgeted for it.
Don't Expect a Loan to Be Paid Back
This is also one that is hard to learn - and for many people the hardest to accept. And, it may not be the right personal finance (remember - it's personal) rule of thumb for you. What works for me may not work for you and that's okay. But, if you are ever in a position to loan money to someone, definitely give your perspective on this some consideration and decide how you want to approach it. Other approaches I've heard include:
Never mix friendship/family and money
Always exchange written IOUs for debts between friends/family (even if these are in the form of text messages) so both parties know in writing it's a loan and not a gift.
Only give money as gifts - if someone else needs to treat it like a loan allow them to do so.
This is certainly not all potential perspectives here but it is interesting to see the variations. For instance, the third item in the list - only give money as gifts - is very different in my mind from my perspective of not expecting a loan to be paid back. I am making you a loan - it's your choice to treat it responsibly or not. Because I treat things as loans you can ask once and not pay it back but asking a second time will probably get a no from me. I could see if my philosophy was to always give money as gifts I might be more giving to the same person long term.
I've been in many positions to share my good fortune with other people. For the most part I'm happy to do so. But one of the things I learned early on about friendship and money is to never expect a loan to be paid back - at least not if you want to maintain the friendship. For that reason, I only make offers of money that I could sacrifice without being paid back.
One of the interesting things that I've recognized since adopting this perspective is that I actually get paid back far, far more often and much more quickly. While this may be mostly because I and my friends are in a much different phase of life, I think it's also because I am no longer focused on the debt as an "issue" in our friendship. I'll get paid back when and if the friend can pay me back but I made the loan with the understanding that it may turn into a gift and that's okay. That said, as I noted above, I may not be willing to make a second loan to that same person.
Finally, it needs to be said that you need to give from what you have and not from how you want to be seen. Don't go around buying lavish meals and paying for a round of drinks or making loans to family members or friends that you can't actually afford. I treat this like the airlines - put on your oxygen mask first before helping someone else. Get your own financial house ordered before you take on someone else's debts.
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