Acceptable Forms of Personal Debt
Although I have been harsh on debt and believe we should pay cash for as many things as possible, I acknowledge that some forms of debt may be the best way to meet some of our most critical spending needs. When used wisely and sparingly, it can provide tremendous opportunities for economic improvement that may never be available otherwise.
In my opinion, the most responsible use of personal debt would be limited to reasonable amounts for education, a modest home, and basic transportation. It may also be prudent for businesses to incur certain forms of debt at sensible levels for expansion that would be impossible otherwise, but we will limit our discussion here to personal debt.
Why am I okay with debt for these purposes? Since higher education often dramatically improves potential earning power, and since our ability to earn an income is typically our greatest asset throughout most of our life, student loans may produce a higher long-term return than any other investment we could make. If a student’s parents or grandparents cannot afford to pay higher education costs for her, she may never be able to save up enough money on her own to pay for the schooling required to increase her earning power so substantially. In this case, student loans can be a very valuable tool.
Still, we must be careful not to spend more on education than we can reasonably expect to be able to pay back based on the earning potential of employment opportunities related to our field of study. We can minimize the use of student loans by seeking to qualify for as many scholarships and grants as possible and by working part-time. We should also remember that paying exorbitant tuition expenses for the most prestigious schools will not necessarily result in significantly higher earning potential than we could attain from lower-cost alternatives.
Financing the purchase of a modest home can be a smart move if the monthly mortgage payments are comparable to what we would be paying to rent a similar place because over time rents may increase, but mortgage payments normally stay the same and eventually become paid off. We can also participate in any potential appreciation of the value of the home.
However, we must be careful not to bite off more than we can chew. We should keep our mortgage payment within 15% of our gross income. We should also shy away from purchasing a home if we are only planning to stay in it for a short time because short-term real estate prices can be very unpredictable. If only staying somewhere for a short time, renting is a much better solution because of its flexibility and the avoidance of other expenses associated with home ownership, such as property taxes, insurance, maintenance, and repairs.
We may need our own car to be able to earn an income, even if we cannot afford to pay cash for it at first. Renting a car for an extended period would be way too expensive, so it might be best to buy our own car on credit, as long as we get a reasonable interest rate and do not pay too much for it. Even though we may want a brand new Lexus right away, it would be better to start with something less expensive just to get us to work, then save up to buy a Lexus later.
Everything else we buy ideally would be paid for with cash. Those who live by this rule find themselves much happier, less stressed, and less susceptible to all of the inevitable unexpected events that are a normal part of life.
Adam Dawson, CFP® is a Principal at Capstone Capital and the author of Timeless Principles of Financial Security.
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