Your Guide to Understanding Debt: Money 101

Is Debt A Dirty Word?

Well, it does have four letters. I suppose it can be.

Like so many things, though – the internet, self-confidence, stylish footwear, pizza – it’s really not about “good” or “bad” so much as it is moderation. Are you using the internet, or is the internet using you up? Are you too insecure to function, too vain to improve, or do you have just the right balance of self-confidence to get things done and inspire people to want to be around you? Do you have enough shoes, or are you giving Imelda Marcos a run for her money?

As to pizza… well, there’s really no such thing as too much pizza. I don’t know what I was thinking by including that one.

Understanding debt means recognizing the many different forms it can take and the various roles it con play. Some of these are very specific to your situation, but many are far more common than you’d think. Debt free living is a nice concept, and may even have some debt advantages, but in the 21st century it’s certainly not common, even among people most of us would consider successful and well-balanced.

But there is such a thing as too much debt. I’d argue there’s also such a thing as too little. I know, I know… but hear me out. You don’t have to agree right away, but you will by the time I’m through. (See – just the right amount of self-confidence. Do you love me now?)

Debt, whether individual consumer debtbusiness debt, or even national debt, is a tool. When it serves your purposes, it’s a very useful and flexible tool. When it somehow takes over or derails your plans, it can be a tough beast to kill. Understanding debt is the first step towards giving ourselves the power to determine which way it plays out.

Let’s look at a few specific sorts of debt and I hope you’ll see what I mean.

Mortgages

“While I encourage people to save 100% down for a home, a mortgage is the one debt that I don’t frown upon.” (Dave Ramsey, radio show host and businessman)

For most Americans, buying a home means taking on the largest debt they’ll ever experience in their lifetime. And yet, home ownership is encouraged in the U.S. – socially, politically, and even economically. It’s considered good for you as a homeowner or family, good for your community, and good for the country for more people to own homes. That means more people in huge debt!

A century ago, the most common mortgage required half down (yes, HALF the total cost of the house) and the balance was paid out over five years. Needless to say, that limited home ownership rather severely to either those born into money or couples who’d worked rather hard for many years to save enough to take the plunge.

Understanding Debt: A Brief History of the 30-Year Mortgage

During the Great Depression of the 1930s, Congress created the Federal Housing Administration along with this crazy new idea of the 30-year mortgage with a relatively low down payment – sometimes less than 10%. This allowed more people to purchase a home, which was good for the people, the community, etc. This had several indirect impacts as well:

  • It raised the overall quality of homes, since homes had to meet certain standards to qualify for a 30-year loan. Since the home itself generally acts as collateral for the loan, lenders understandably wanted some assurance values could be maintained over time. Builders or other home sellers of course strove to meet the requirements, since there’s no point offering people homes they can’t get loans on.

  • That same set-up helps keep interest rates under control. Because the home acts as collateral for the loan, lenders aren’t taking the same risk they would be on an unsecured loan. Plus, the same extended length which makes homes affordable to buyers means lenders make a reasonable profit even at these lower interest rates, pushing them to remain competitive in order to secure as much of the market as possible.

  • Over time, American homes have generally gotten larger. This hasn’t been true in every region during every decade, but the overall size of homes has increased, leading (along with other factors) to general rise in housing prices. This is only possible because so many people can afford “more house” thanks to the debt they’re offered by a 30-year mortgage.

Mortgages are also the kind of debt most often refinanced when interest rates improve or your personal circumstances change, making it one of the more flexible forms of debt you’ll encounter. It’s usually still a LOT of money, but the system is generally designed to make it as doable as possible for you to make your payments and own your home.

Of course there are bad mortgages, just like there are bad homes, but overall, debt financing a home is happy debt – a net positive.

If you want to know more about mortgages, check out Mortgage Loan Basics Spelled Out: Lending 101, a guide to understanding debt as it relates to the biggest purchase most of us will ever make.

Auto Loans

“If you think nobody cares if you’re alive, try missing a couple of car payments.” (Earl Wilson, American newspaper columnist)

Car or truck payments aren’t quite the same as buying a house, but they have a few things in common. The biggest, I’d argue, is that many of us wouldn’t be driving whatever we’re driving at the moment if we weren’t able to finance it. “Financing,” of course, is just a fancy word for “going into debt” for something.

Is having a car you like such a bad thing?

Now, there are potential downsides to auto financing. Thanks to the internet and the proliferation of information, including things like dealer cost and blue book values, dealers are no longer able to strong-arm customers the way some of us remember from a generation ago. While they have every right to make a reasonable profit, it’s not as easy as it once was, and some try to make up some of that difference through the financing they push on you at the time of sale. (It usually comes right after they insists you need that ‘floormat protection spray and extra roadside protection package for a zillion extra dollars.)

Just like blue book values and dealer costs, though, the internet has changed everything when it comes to auto financing. It’s much easier to get help understanding debt in relation to an auto loan (or mortgage, or any other sort of loan) thanks to the many online loan calculators out there. It’s great to understand the many elements of a loan, but even if you’re a little fuzzy on the mechanics, you can simply run the numbers on as many variations as you like and see what it does to your payments and the total amounts you’d pay over the life of the loan.

While you should absolutely check with your local bank or credit union, and hear out what the dealer has to offer (sometimes the major manufacturers offer killer financing deals to help move inventory), you also now have access to online lenders who – unlike that “floor manager” I remember sitting with thirty years ago who wouldn’t give my driver’s license back so I could leave – are eager to earn your business. They want you to not only be happy enough with them to take out an auto loan, but to tell your friends a year from now and five years from now what a great move it was to do so.

The secret to making auto loan debt “good debt” instead of yucky evil “bad debt” is to do your financing homework before you start looking at actual cars or trucks. Pre-approved financing gives you enormous flexibility, and time to think things through before you commit. Then, if the dealer has some financing offer you can’t pass up, you can take it. If you’re not happy with the dealer’s terms, however, you’re still negotiating from a position of strength.

Understanding Debt: Rebuilding Credit Through Manageable Debt

The other advantage to the expanded choices offered by online lenders is the opportunity they provide for those of us with no credit history, a shaky credit history, or even a rather awful credit history to begin building or rebuilding that credit. I don’t know about you, but that’s the sort of thing I’d rather negotiate with lenders who want very much to figure out something that will work for both of us, at my own pace in front of my own computer, than sitting across from “Carl-in-charge-of-financing” who keeps typing stuff and looking very concerned at his monitor (which I can’t see).

None of this guarantees you won’t commit to more than you can afford when buying a new (or new to you) vehicle, but it certainly helps give you the room to make a more reflective and informed decision.

If you want to know more about auto loans, check out Auto Loan Basics Spelled Out: Lending 101, a guide to understanding debt in relation to vehicle shopping and purchasing. It’s a whole other kind of experience.

Business Debt

“In every success story, you will find someone who has made a courageous decision.” (Peter F. Drucker, management consultant, educator, and author)

OK, I’ll admit it. This is a riskier type of debt than a mortgage or auto loan. That’s the whole nature of business, though, isn’t it? Taking that risk?

At least with homes or cars there are endless statistics and calculations and relatively objective ways to determine whether you’re paying the right price or getting a good rate or choosing the right location or model. Those still come with an element of risk, of course – everything in life does – but nothing like starting or running your own small business.

There are statistics you should look at, of course. Numbers to run, projections, surveys, data, and all that. But more than with any other type of debt, small business development at some point requires a leap of faith. A moment of insanity. One which, statistically, simply may not work.

Then again… it might. So there’s that.

Business loan debt has a few fundamental things in common with any other sort of debt. You need documentation, you should shop around, your credit history matters, you need to make your payments on time, etc. All that big stuff. Understanding debt in fundamental ways is just as essential here as in any other part of our fiscal world.

On the other hand, small businesses have needs unique not only to small business, but to your business, whatever that might be. Here are just a few reasons a small business might choose to incur some debt in the pursuit of greater growth or success:

  • Physical Growth – You need more space, a bigger building, more land, more production facilities.

  • More Inventory – You need stuff to sell or use as part of your service.

  • Updated Technology – Time to replace those computers, phones, or other tech essential to remain competitive.

  • New Equipment - Industries change; maybe you have to change with it to remain profitable.

  • Seasonal Growth – You know the profits are coming, but to be ready you have to spend money you don’t have yet because each year it’s a little more.

  • Establishing Credit – Maybe you could squeak by without borrowing, but you know at some point down the road, if things keep going the way they should, you’re going to want access to greater financial flexibility, a higher limit, or a better rate. Small, manageable business loans now (which you of course pay off in a timely manner) lay the groundwork for larger, better loans later.

Understanding Debt: When More Business Loans are a Bad Idea

Just like with any other sort of loan, however, there are times when your small business may be tempted to borrow money which is not such a great idea. Businesses tend to deal with larger amounts, and because they hopefully have some income, it’s much easier to convince ourselves that the Profit Fairy is on her way.

  • Plugging Holes – You’re falling behind more and more each month but keep telling yourself you have to “believe” and it will all work out, despite the lack of a clear business plan or reality-based projections suggesting this is likely to happen soon.

  • Swinging for the Fences – You keep trying things figuring eventually something will work or be the “next big thing.” You want to burn through resources this way when you have money in the bank to spare, that’s between you and your accountant. But, like lottery tickets, don’t play on credit. Ever.

  • Stealing from Yourself – You’ve been diverting business money to personal expenses (or entertainment), figuring you’ll pay it back when things get back on track. Hopefully you’re not defrauding anyone else in the process, but you are deceiving yourself at this point, my friend. Stop digging that hole and regroup before you do real damage to your business, your credit rating, and possibly any number of professional (or personal) relationships.

I’m not trying to discourage you. In the end, you’re the one making the call. I’m just offering my seasoned insight and profound wisdom; what you do with it is up to you.

If you want to look at more reasons for and options with business loans, check out Business Loan Basics Spelled Out: Lending 101, a guide to understanding debt in relation to your small business.

Credit Cards

“Nowadays it’s not who wears the pants in the family; it’s who carries the credit cards.” (Anonymous)

Of the four common types of debt we’re addressing today, this one is admittedly the most problematic. The same freedom plastic gives us to order, reserve, or purchase as we wish, without extensive planning or more than a few simple steps, makes it far too easy to buy on impulse or commit beyond our means. If our goal is understanding debt, some part of that is understanding human nature, and ourselves, and the way the system is set up to profit from these things.

Because we’re not taking actual paper money out of our purse or wallet, or even writing large numbers out laboriously on a paper check, we’re an additional step removed from just what those numbers represent in terms of the labor we’ve put in to earning them or the potential suffering which could result from not having enough of them.

And credit cards are designed to profit the issuing organization. That’s not malicious, it’s just how capitalism works. Credit cards are more of a risk than home or auto loans. People are more likely to let a credit card payment slide than a house or truck payment, and it’s difficult to send someone to repossess last year’s vacation or a thousand music downloads. As a result, the interest rates tend to be higher.

I don’t say that because I think the system is “out to get you.” That’s just how capitalism works. Understanding debt doesn’t have to make you cynical, but it should help you remain realistic. Market forces, supply and demand, and what Adam Smith called the “invisible hand” make it possible for you to have a phone in your back pocket that can surf the web, play games, take far better pictures most real cameras could a generation ago, and communicate with pretty much anyone anywhere in the world. It means quality restaurants compete for your business while everything from auto shops to hair salons try to give you better service for less money, not because they love you as a person, but because they want your money.

Not incidentally, it’s also why online lenders are giving so many brick-and-mortar banks a run for their (literal) money by offering flexible terms and competitive rates, even for folks with a limited credit history or a not-entirely-wonderful credit score. But be honest, would you rather hold out for someone who appreciates you for your personal charm and clever accessorizing, or someone whose livelihood depends on making you happy as a customer and hoping you’ll tell others about them as well?

That’s a no-brainer to me… but I digress.

Of course, there are plenty of entities looking to manipulate and exploit you through that exact same system. That’s why we have laws, that’s why professional organizations have standards, and that’s why it’s on you to educate yourself whenever possible about the option before deciding what makes the most sense for you. I assume that’s part of why you’ve read this far – it’s part of understanding debt in its many forms.

Let me give you a personal example…

Understanding Debt: (Re)Building Credit Through Responsible Credit Card Use

My primary credit card for years was from a major financial organization whose name we’d all recognize. The card carried an interest rate my wife found horrifying. (I already had it when we met.) She would have never carried, let alone used, such a card. I, on the other hand, was grateful for it.

See, I had horrible credit. I’d made some bad choices, repeatedly and over a long time, and it took years of digging out with the help of a local credit counseling agency to get myself back on track. It wasn’t pretty, but I emerged understanding debt on a much more personal level as a result. When I needed a credit card as a practical matter, it was a challenge. I was a poor credit risk, based on my history. But this lender took a shot. My new card started with a relatively low credit limit and a rather high interest rate, but it allowed me to begin new habits. Better habits.

Eventually they raised my credit limit. One day a competitor offered me a card at a much lower interest rate, which I took as well. I didn’t get rid of that first card, however, even though I don’t use it much. I keep it partly for emergencies, and partly because available credit I’m not using up helps my credit rating. Mostly, though, I keep it because I appreciate them taking a chance on me.

I’m thankful for that “high interest” credit card in a way I could never be for those sketchy “fast cash now” or “payday loans” places, because it wasn’t one more act of desperation on my part; it was an informed decision towards a better approach and more options. The company made a decent profit off me in interest over the years. In the meantime, I rebuilt my credit partly by using the card and paying them for the opportunity.

Other Positives of Responsible Credit Card Use

Credit cards make it easier to do business online. Most have built in fraud protection, and if they don’t, you should switch to a card that does. I reserve hotel rooms with credit cards, book flights with credit cards, and when I do order stuff online – because I’ve thought it through and budgeted for it and genuinely want to do it – I use credit cards as well. I don’t pay them off every month (like my wife does hers), but I pay enough that it’s a good deal on both ends.

Some folks use cards almost exclusively so they have a detailed statement at the end of each month where their money is going. That’s not my thing, but if that’s how understanding debt works for you, more power to you. I have friends who are very good at using points and miles and discounts and such they receive as part of their chosen credit cards. I don’t get it, but it seems to work for them.

And of course there’s the possibility of consolidating your debt through the right credit card, or rebuilding your credit as I did. They are nothing of not flexible. It’s all about exploring the options and making informed decisions.

The Dangers of Credit Cards

Before you get all excited and accepting every card you’re offered, t’s worth asking how I ended up in such severe debt to begin with. How did I make enough bad choices to end up over $10,000 in the red despite barely making that amount in any given six-month period?

Wanna take a guess?

Of course some of that was credit card debt! One major card, several department store cards, combined with car loans I didn’t plan well and generally shoddy budgeting (by which I mean I didn’t actually budget at all) allowed me to get buried deeper and deeper. It can happen all sorts of ways, but credit cards do this the best.

It’s unlikely that the lender to whom you send your truck payment will send you a notice one day, long before your loan is even paid off, that they’re raising your limit so you can buy more cars. There’s a natural ceiling on how many homes or cars you’re likely to want in a short amount of time. Not so with credit cards. They don’t want you to default on your payments completely, of course, but they don’t particularly want you paying your entire debt too quickly, either. While they’ll sound quite serious about it, most aren’t too upset if you’re late from time to time, as long as you eventually do make those payments, along with the hefty late fee they’ve tacked on.

The ideal credit card user from the issuing company’s point-of-view is someone who keeps using the card and making minimum payments or slightly more, but whose outstanding balance continues to creep up over the months and years. And why not? The higher your balance, the more interest you pay. That’s why those “minimum payments” that show up on your bill aren’t enough to actually lower your balance over time. They’re just enough to let you keep owing.

So understanding debt as it relates to credit cards means two things: understanding the system and understanding yourself. As with the examples we used at the beginning – food, alcohol, internet, etc. – credit card debt isn’t evil, but it has the potential to be destructive. You know yourself, your tendencies, and your personality. Should you even mess with plastic money, or go another route? Can you manage it to serve you, or is it likely to own you instead?

The answers, whatever they are, don’t make you a good person or a bad person; they make you honest with yourself. And that’s more than most of us manage, if we’re being real about it.

If you want to know more about the pros and cons of credit cards and how they work, check out Credit Card Basics Spelled Out: Credit 101, a guide to understanding debt in relation to those little plastic rectangles in your purse or wallet.

The Debt Snow Ball Method:

Debt-Snow-Ball-Method.png

The Snow Ball Method to paying off debt is a great trick to help you get out from under all those payments. Basically, what it says is pay off the lowest amount first and snowball your way to the bigger payments. In other words, start with that $300 Macy’s card and eventually chip away at the other credit cards, auto loans all the way up to your mortgage principle. It works both psychologically and mathematically. So, why not give it a try.

The Verdict

Whether debt is a positive or a negative is largely up to you. It’s about how you use it. Keep up with an online spreadsheet, install a debt tracker app on your phone, or whatever else you need to do, but take control. Make informed, reasoned decisions. Because if you don’t control your debt, it may end up controlling you.