What Debt Is Acceptable And What Debt Is Foolish?

I don’t know how anyone is supposed to learn about money these days.

Here’s how our culture treats money and financial discussions.

We’re not supposed to talk about money.

Don’t tell anyone how much you earn.

Don’t let anyone know you owe money.

Want to ask questions to try to understand money? Don’t if it shows other your money situation.

Simply go through life doing what is supposed to be normal and hope you can eventually retire one day.

Today, I want to help change your life. One of the most confusing aspects of money management is debt. What debt is acceptable? What debt is foolish? Do I owe too much money? Could I borrow more?

I hope you find the answers to these questions by the end of this article. If you use debt reasonably and try your best to avoid unnecessary, foolish debt, you’re well on your way to a successful financial future.

Acceptable Debt

In an ideal world, no one would ever have to borrow money. We’d save up for everything we want to purchase in advance then buy the item only after we have the money in the bank.

Unfortunately, that isn’t realistic for a handful of major financial milestones most people desire to achieve. I do believe some debt is acceptable, but only when the amount of debt is reasonable and you’ve spent plenty of time planning and analyzing the purchase.

Here are the types of debt I feel are acceptable and how you can make sure you keep them reasonable.

A Reasonable Mortgage

Owning a home is part of the American dream. In some areas of the country, owning a home is a smart financial decision that could save you money if you play your cards right. In other areas of the country, renting may be cheaper.

Regardless of whether owning or renting is cheaper, owning a home is a lifestyle decision. If you plan to stick in one place and enjoy the chores of owning a home including repairs and maintenance, buying could be right for you.

If you do decide to buy, you’re probably going to need a mortgage. After all, very few people can pay for homes in cash early in their lives. That’s okay. I believe a reasonable mortgage isn’t anything to be ashamed of.

That said, I do think you need to have your ducks in a row before you start house shopping.

In an ideal world, you’d have enough money to put 20 percent down on your new home. That could be a stretch, but it is a good indicator you’re on solid financial footing.

You’ll also need to make sure your mortgage payment isn’t insane. Don’t let bankers tell you how much of a mortgage you can afford. Calculate the numbers yourself. What fits comfortably within your budget? Only you can answer that.

As a rule of thumb, I wouldn’t suggest anyone spend more than a third of their income on housing. That includes your mortgage, insurance, taxes, maintenance, HOA fees and all other housing costs. If you like to play things safe, stick to a quarter of your income or less.

Ideally, you’d keep the number as low as possible. At one point, my housing was less than 10 percent of my income. You can make it happen.

A Reasonable Car Loan

We’re a car obsessed culture that views cars as status symbols. While cars may be status symbols to some people, they shouldn’t be. It’s an easy way to blow hundreds of thousands of dollars over your lifetime.

In reality, cars are transportation. They get you and your family from point A to point B safely. For many people, cars are necessary to commute to work and earn money. As such, a car loan isn’t the end of the world if it is reasonable.

On the other hand, you should only need a car loan the first or second time you buy a car. After that, you should be able to start buying cars in cash.

If you want more details, here’s exactly how you can buy your next car, or at least the one after that, in cash.

A reasonable car loan requires buying a reasonable car. Usually, that means avoiding luxury cars and sticking with quality, time tested car models that will last. In many cases, you can usually save even more money by buying used.

Personally, I think car loans shouldn’t exceed 36 months or 48 months in a worst case scenario. You shouldn’t ever need to finance more than $20,000 either. Honestly, I think you could even get away with only financing $10,000.

No, you won’t be able to afford buying a luxury car with a reasonable car loan. You probably won’t be able to afford a new SUV or minivan, either.

However, you can buy a reasonable car today and save your money until you can eventually buy the car you want with cash down the road. How can you do this? Driving your cars longer.

Quality cars can easily last 10 years and at least 100,000 miles today. I don’t think it’d be a stretch to say many can make it to 20 years and 200,000 miles, too.

Yes, you may have some maintenance costs, but you’ll likely save tens or hundreds of thousands of dollars over your lifetime by keeping your cars longer.

Reasonable Student Loans

My wife and I hate student loans. Why? My wife ended up with $80,000 of student loan debt for a four year nursing degree. Thankfully, we paid it off in less than 3 years, but we definitely aren’t normal.

If you’re just getting ready to head of to college or you’re just about to start a graduate degree, please listen.

Student loan debt is very dangerous unless you have a plan. Before you take out any student loan debt, you need to have a realistic idea of how much money you’ll earn with your degree after you graduate.

You’ll also need to have an idea how much debt you’ll need to take out to earn that degree and what the monthly payments on that debt will be.

Will your future student loan payments be affordable on your expected future income? If not, you can’t afford to take out the student loan debt. You’ll either need to find a way to pay cash for your education, choose a different degree or skip out on college.

Here’s a quick example to give you an idea.

Let’s say you graduate with $50,000 of student loan debt at 4.5 percent interest and you earn $50,000 per year.

Your debt payment, assuming a 10 year repayment term, would be roughly $518. Your monthly income would be about $4,167 before any expenses and taxes.

Right away, you’d spend about 12.5 percent of your monthly income on student loan debt payments for the next 10 years. Only you can decide if student loans are worth it.

The one piece of advice we have about student loans is to try to keep them as low as possible. Only buy what is truly necessary.

You won’t remember 10 years from now what you spent that money on and if you’re somehow still making loan payments, you’ll probably wish you had spent a bit less.

Medical Debt

I don’t even know how to address medical debt. It’s crazy to me.

First off, elective medical debt is insane and foolish. You don’t need elective plastic surgery if you don’t have the cash to pay for it. Just don’t do it.

However, if you have to go into medical debt to survive or significantly improve your quality of life, I don’t see how you can avoid it.

Things happen. Do your best to avoid medical debt if at all possible.

Make sure you always have health insurance. Get second opinions when your gut says something is wrong. Price shop where you can without sacrificing quality of care.

No one can prepare for the major medical surprises that often leave behind medical debt.

Cancer, broken bones, freak accidents and car wrecks happen. If I had to choose between fighting for my life or avoiding debt, I’d choose fighting for my life every time. You should, too.

Once you’re in medical debt, do everything you can to negotiate the debt to the most reasonable number possible. Then, make payments as you can until the debt is eventually gone. Worst case, you may have to claim bankruptcy.

Medical debt is crazy, but I have to say it is acceptable. At the end of the day, I’d rather be in debt and be alive than avoid debt and be dead.

Foolish Debt

In my mind, all other personal debt other than the types of acceptable debt listed above are foolish.

Before you get upset, I do understand that the past is the past. You can’t change what has already happened. If you have any of the types of debt listed below, don’t feel ashamed.

You may have been in a tough spot or simply thought it was normal to have these types of debt.

What is important is you understand that they are not acceptable. You should work hard to pay these debts off quickly so you can move on with your financial life.

Avoiding these types of debt will give you a chance to start growing your net worth. Eventually, you may even be able to retire or even reach financial independence and retire early.

Payday Loans

Payday loans are some of the most evil and foolish loans available. These lenders will take advantage of people in awful situations and put them in an even worse situation.

They charge insane interest rates that can end up keeping borrowers in debt for not just one, but many paydays.

If you think you need a payday loan, stop and think about your financial life.

Do you have a cell phone you can cancel? Do you have cable you can cancel? Can you move in with your parents? Are there any public assistance programs that can offer food or other assistance during your time of need?

Payday loans should never be used and, if you still have payday loan debt, should likely be at the top of the list of loans you pay off as fast as possible.

Credit Card Debt

Credit card debt is a fact of life for most people. Interest rates can vary from a “reasonable” less than 10 percent to insane rates such as 29.99 percent.

Credit cards allow you to buy something you can’t afford to pay cash for today by simply paying more for the item. Of course, when we buy the item, we only see the price tag, not the final cost of the item with interest added.

You won’t likely ever earn a consistent 10 percent return on your money and you definitely won’t earn 29.99 percent. So why should you borrow money at these rates? You shouldn’t.

I do advocate for using credit cards responsibly and paying them off in full each and every month. I do not believe you should ever carry debt on a credit card.

It’s easy to think you’ll be able to pay off a credit card balance then have something pop up. If this happens to you, you should probably stop using credit cards. Instead, use a debit card or the cash envelope system.

Credit cards used responsibly can be a great tool. Used foolishly, they can destroy your financial future.

Cash Advances

Cash advances from credit cards are an expensive proposition. Most times, you have to start paying interest immediately and you have to pay a fee to get the cash advance. The interest rates usually are sky high.

If you really need cash, sell something from around your home. Cut back in other areas of your budget. Whatever you do, avoid cash advances like the plague.

Personal Loans

Taking out a personal loan can be a reasonable idea if you’re ready to dig yourself out of debt once you hit financial rock bottom. However, taking out a personal loan for any other reason is usually a foolish decision.

Personal loans are usually unsecured debt and come with high interest rates. The rates can be lower than credit cards and payday loans, but they’re still higher than you should be paying.

It may be tempting to take out one of these loans to pay for a fancy toy like a motorcycle or a boat. You could even be tempted to take out a personal loan to help pay for Christmas gifts.

Regardless, personal loans are rarely used to improve your financial situation and should be avoided. If you need a personal loan to make a purchase, you can’t afford that purchase.

Like I mentioned earlier, personal loans can be a great way to help you get out of debt. Refinancing higher interest rate debt to a lower interest rate personal loan can save you money and help you pay off your debt faster.

However, personal loans only help if you stop incurring all other debt. If you run up your credit cards again, taking out a personal loan will dig your debt hole even deeper than it was before.

Home Equity Lines Of Credit And Loans

Home equity lines of credit and loans seem like an acceptable form of debt to many people. Unfortunately, you’re only shooting yourself in the foot if you’re borrowing from your home equity in most cases. This type of debt is downright foolish.

What do people use home equity loans to buy? Upgrades to their homes, new cars, things they can’t afford to pay cash for like boats, motorcycles and RVs.

None of these things are needs. They may be nice, but if you can’t afford to pay cash for these items, you shouldn’t buy them.

Even worse, home equity is one of the few ways Americans generate wealth. When you borrow against that equity, you’re destroying the little wealth you’re creating for yourself. Cash out refinances are just as bad.

Ideally, you’ll have a paid off mortgage by the time you retire. Home equity lines of credit make that goal even more difficult to obtain. Don’t take out a home equity line of credit or loan.

Borrowing From Friends and Family

Borrowing from friends and family is both foolish and painful. You may end up getting a loan with no interest, but the stress these loans cause simply isn’t worth it.

Loans from friends and family can easily destroy your relationship. If you don’t pay the person back according to the rules they have in their head, you’ll be walking eggshells every time you’re around them.

Say you borrow $500 for a specific purpose, then go on a vacation you already paid for before you borrowed the $500. Your friend or family may think you’re not making repayment a priority and get upset.

Just don’t do it. Your relationships are worth more than money.

Tax Debt

Tax debt is one of the most brutal types of debt you can get yourself into. The IRS has many ways of getting their money, many of which come at some of the most inopportune times. They can garnish your wages, keep your tax refunds and make your life a nightmare.

Avoid tax debt by making sure you withhold enough from each paycheck to cover your annual tax liability.

If you earn any money outside your job, make sure you set aside enough money to cover the taxes you’ll owe. You’ll owe both income tax and self employment taxes in many cases.

You may need to file quarterly estimated tax payments if you earn enough money outside of your job. Make sure you understand your responsibilities so you don’t end up in tax debt.

Your tax bill should stay at the top of your list of debts you want to avoid.

401(k) Loans

Whoever came up with the idea of 401(k) loans has likely hurt many more people than they have helped. It doesn’t seem like a big deal to borrow money from your retirement account and repay it with interest, but it is.

First, whatever you’re purchasing with a 401(k) loan probably should be paid for with cash. If it is a major expense, you probably should have been saving for it ahead of time.

There is no good reason I can think of for taking out a 401(k) loan that couldn’t be taken care of using a better option. Why? Sadly, 401(k) loans don’t always turn out like you would hope they would.

If you have to leave your company or get terminated before you pay the loan off in full, you’ll likely have to repay the balance of what you owe over a short time period, possibly 60 days or less.

If you’ve already spent that money, chances are you won’t be able to repay the loan, especially if you just lost your job.

Then, the loan ends up as a distribution where you have to pay income tax on the distribution amount and a penalty for taking money out of your 401(k) before retirement age. You probably won’t have money to pay for that, either.

You may think you’re in a secure position in your job. That said, you never know when family circumstances will pop up. Your employer could end up going under. Profitability may tank and require lay offs.

People aren’t always fired for their actions. Sometimes you’re just a victim of bad timing. Having a 401(k) loan during that bad timing could destroy your finances.

Furniture, Mattress And Other Major Purchases Debt

Any time a store is willing to offer you 0 percent financing to make a consumer goods purchase, you should run unless you can pay cash.

You should never go into debt to buy furniture, mattresses or other purchases that are only a few hundred to a couple thousand dollars.

Companies often offer financing that lasts for years to purchase these items. The joy of having new furniture or a new mattress rarely sticks around longer than the monthly payments do.

Instead, buy more affordable versions of the items you’re looking to buy, or, if you’re really in a bind, consider buying used from craigslist or a consignment store.

If you can’t pay cash, you shouldn’t be buying it.

House Maintenance Debt

When you buy a house, you must realize you’ll have to maintain that house. Set aside money every month so you can pay for these maintenance items when they pop up.

Whether you need to get your air conditioner serviced, a drain unclogged or a hot water heater replaced, these are facts of life for a homeowner. Don’t let them surprise you.

Taking out debt to pay for these items may be your only option if you’ve waited until the last minute and haven’t saved a dime. If that’s the case, you need to start saving for your next housing maintenance mishap today so the same foolish mistake doesn’t happen again.

Appliance Loans

Just like you can finance furniture and mattresses, you can finance household appliances. It’s ridiculous.

Why would you finance a $2,000 refrigerator you can’t afford when you can buy one that works just fine off of craigslist for less than $200.

It may not look pretty, but it will get the job done until you can save enough cash to buy the $2,000 version if that’s what you really want. Chances are, you can sell the old refrigerator for the same $200 you bought it for when it comes time to get the new one.

Life Insurance Loans

Life insurance loans are super foolish because you can only take them out on life insurance you probably shouldn’t have in the first place. When you have a permanent or whole life insurance policy, it has “value” you can take out a loan against.

The thing is, if you had invested the amount of money you put into your whole life insurance premiums, you’d probably have more money.

Even better, take out a term life insurance policy and invest the difference in cost between the whole and term life insurance policies for the best of both worlds.

If you have a whole life insurance policy, look into term life insurance. For 99 percent of people, term is the right move.

No you won’t be able to take out a loan against it, but that’s a good thing. One less type of foolish debt to worry about.

What Do You Do Now?

Now that you have a better idea of how debt should really be used, it’s time to put this information to work.

First, don’t be ashamed of your current debt. Instead, work to pay off your foolish debt.

If you don’t know how to start paying off your debt, I highly suggest my series addressing that exact problem which you can find here.

Going forward, you should work hard to only take out acceptable debt. Other purchases should be made only after saving up cash before you make a purchase rather than taking out foolish debt to complete a purchase.

If you simply follow the guidelines above and apply them to your life, you could end up much wealthier down the road.

Of course, every person’s situation is unique. There are rare circumstance when acceptable debt for one person is foolish debt for another and vice versa. Use your common sense and do what is right for you.

If you’re still confused or would like an opinion on your exact situation, consult a personal finance professional. Make sure they understand your full situation and are only compensated for their time, not for their actions.

What questions do you have about foolish and acceptable debt? I’d love to help answer them.

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About Lance Cothern

Lance Cothern, a Certified Public Accountant (CPA) licensed in the Commonwealth of Virginia, is the founder of Money Manifesto. You can read more about him here or connect with him on Facebook, Twitter, Google+ or Pinterest.

Comments

  1. You Americans are so crazy. In Germany you can have the worst of all diseases and end up with no debt at all. Even if you live on social security the state provides you health care. In Germany no one dies of treatable diseases because of money issues. You could go everyday to the physician and you’d have to pay nothing. That’s why painkillers aren’t a big deal in Germany. If you don’t feel well you don’t eat painkillers for months and hope it vanishes, no you go to the physician.
    Life in the US must be hard for poor people.

  2. I agree with all your ‘good debt’ examples, except for car loans. In my humble opinion, car loans are a bad idea.

    Although often times cars are a necessity, there are plenty of cheaper options to opt for if you can’t afford a good car right now.

    I’ve carpooled, walked and used public transportation for months before purchasing our first car, and even with money saved up we could only afford a used one, with a very small engine and many, many miles on board.

    However, it safely took us from point A to point B, until we managed to save up for the next one.

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