Is All Debt Bad?
By Kevin Estes
Debt is a Tool
It’s a powerful one at that!
Like any tool, it has uses and must be handled with care.
Pros and Cons
Using debt has big benefits and drawbacks.
Pros:
current spending
credit score
protection
rewards
current opportunities
Cons:
higher spending
interest and fees
future flexibility
credit availability
financial risk
Pro: Current Spending
Credit lets someone to buy today and pay later.
It’s often better to delay gratification! However, that may not be ideal in some situations.
Lifetime Income and Spending
Income generally varies more than spending throughout our lives.
According to household data from the U.S. Bureau of Labor Statistics:
Income for 45-54 year olds was nearly three times that of those under 25 or over 75 years old.
Expense for 45-54 year olds was less than double that of those under 25 or over 75 years old.
College Students
Full-time college students have it worse. Their income is often low while their expenses are high.
It’s jarring how little college students spend!
Living two or three people to a room is common.
Meals are often instant ramen, microwave pizza, and the like.
The standard of living is especially surprising at top universities. Students who’ll earn well over $100,000 a year mid-career live like paupers while attending.
Lifetime Earnings
A young adult has their whole life to earn money. Their greatest asset is usually their human capital.
After they complete their education, they start work. They trade human capital for financial capital.
Most of the money earned is spent. Hopefully, some is saved!
Savings will be needed later in life when income is lower.
Lifetime Spending
American society forces young adults to prove themselves.
Young people generally aren’t allowed to spend until they earn. Older family members don’t want financially dependent adults!
Debt is a rational way to align spending and income. The benefits of eating a complete meal instead of instant ramen may be huge!
Using credit is especially enticing for someone who expects their income to rise.
Young adults use relatively little debt. The debt they have is for long-term assets: homes, cars, and themselves!
According to recent data from the Federal Reserve Bank of New York, 18-29 year olds have the following debt:
Pro: Credit Score
Credit isn’t fair:
Those who need it can’t get it.
Those who have it don’t need it.
Debt is also a bit of a Catch-22. It takes credit to get credit.
Credit scores take years or even decades to build.
Pure Risk
Someone who pays for their expenses out of pocket is responsible! They spend less than they earn and have no need for debt.
Consider who’s riskier:
someone with debt
or without it?
The person without debt has less financial risk!
Proven Behavior
The problem is that expenses are often funded by a family member. How responsible their parents are has little impact on how responsible they are!
Young adults must prove they’re trustworthy. That’s why getting a credit card at age 18 isn’t a terrible idea.
Using the card and paying it off monthly can help build credit history. That keeps their utilization low and slowly ages the account.
Authorized User
Adding a younger family member as an authorized user on a credit card can be a huge gift!
It’s like credit training wheels. Children gain experience using credit without the risk of missed payments.
My family ran a real estate business.
We were surprised that four Notre Dame undergraduate students had credit scores over 800! Their parents had added them as authorized users years before.
The risk is that the children will overspend.
However, that’s a feature, not a bug! Irresponsible students aren’t added as authorized users.
Impacts of Good Credit
It’s hard to understate the importance of a solid credit.
A good credit score can can help someone:
get student loans,
rent an apartment,
buy a car,
lower insurance premiums,
get a job,
buy a home…
According to the Consumer Financial Protection Bureau, the average total cost of credit card debt for superprime borrowers was about a third that of deep subprime borrowers in 2023:
12% for superprime (800+ credit score) and
36% for deep subprime (579 or less).
The benefits are why I usually suggest people keep debt accounts open even when they no longer need them.
Pro: Protection
Fraud cost consumers more than $10 billion in 2023, according to the Federal Trade Commission.
If someone sees fraud on their account, they should immediately dispute it. Both credit and debit cards have protections.
Credit and Debit Difference
However, a key difference can really matter:
Credit card fraud has taken the institution’s money.
Debit card fraud has taken the account holder’s money!
Denied Fraud
What happens if a lender denies a fraud claim?
If it was a credit card transaction, the money in dispute was paid by the credit card company.
If it was a debit card transaction, the money in dispute came out of the individual’s account!
Different Escalation Path
It may seem like splitting hairs. However, play it out a move.
For a denied fraud claim on a credit card, the “borrower”:
doesn’t pay the charge and
continues to dispute it.
The financial institution may have to take legal action against the fraudster (or “borrower”). The company may have to write it off. That’s one reason merchant costs are higher for credit than debit card transactions!
For a denied fraud claim on a debit card, the owner:
continues to dispute it and
hopes the bank gets them their money back.
The account owner may have to take legal action against the bank to retrieve the funds!
Pro: Rewards
Credit cards usually have more favorable benefits than debit cards.
That’s because credit card companies know some people will carry a balance, which earns:
interest charges,
late fees, and
other revenue.
Points
There’s a healthy debate on whether points or cash back is better.
Travel hacking is an art. It can pay for someone who has the time, desire, and patience.
However, racking up airline miles and hotel stays can cause someone to travel more. We’ve also seen how valuable travel rewards can be during a global pandemic.
Fortunately, points can often be traded for cash back. The conversion rate matters.
Cash Back
Cash rewards can significantly improve cash flow:
2% on $50,000 spending is $1,000 a year!
Better yet, it’s usally tax-free. The IRS generally views it as a spending rebate instead of income.
Some cards offer additional cash back for specific categories. Special rates may apply for restaurant, gas, grocery, and other transactions.
Retailers sometimes offer additional cash back for their own transactions. These programs reward loyalty.
Pro: Current Opportunities
Using credit to pay for everyday expenses can take advantage of current opportunities such as:
insurance,
products, and
investments.
Insurance
Someone may be able to lower their insurance premiums by:
increasing their deductibles or
paying six months or a year in advance.
For more, check out Shop Auto Insurance!
Products
Owning is often less expensive than renting long-term.
Furniture is a good example. Owning furniture can be less expensive than renting and it requires someone keep the furniture a while.
Other examples include buying a:
WiFi router instead of renting it from the cable company,
pressure cooker or air fryer instead of eating out,
auto instead of leasing,
Investments
Some investments provide a higher “return” than the debt cost:
Contributing up to the full company match in a retirement plan could be a 50% benefit or higher.
Participating in an Employee Stock Purchase Plan with a 15% discount every six months may be more than a 36% annual benefit.
A married couple in the 24% federal tax braket may save that plus some state taxes by contributing to a Spousal IRA.
Education can also fall into the investment category. It works best when evaluated that way!
What’s the expected income upon graduation?
How much will the program cost?
Con: Higher Spending
Cash is psychologically harder to spend. Credit cards reduce resistance and increase spending.
Paying with cash may even activate different parts of the brain. Using a phone is even easier!
Track speding. If it’s much higher with credit, consider switching to cash.
Con: Interest and Fees
Interest rates depend on the debt type.
Payday Loan
According to the Consumer Financial Protection Bureau:
Many state laws set a maximum amount for payday loan fees, ranging from $10 to $30 for every $100 borrowed.
A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400 percent.
Charging 400% interest a year is outrageous!
Credit Card
The consumer bank interest rate on credit cards was 21.76% in August 2024. That was a sharp increase from 14.56% in February 2022.
Board of Governors of the Federal Reserve System (US), Commercial Bank Interest Rate on Credit Card Plans, All Accounts [TERMCBCCALLNS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/TERMCBCCALLNS, November 18, 2024.
Student Loan
As of February 2024, the average student loan rate for all existing borrowers was 6.87%.
Hanson, Melanie. “Average Student Loan Interest Rate” EducationData.org, February 21, 2024, https://educationdata.org/average-student-loan-interest-rate
Current Interest Rates
New student loan interest rates depend on the borrower and loan type. They’re currently:
Undergraduate direct loans 6.53%
Graduate or professional direct unsubsidized loans 8.08%
Parent, graduate, or professional direct PLUS loans 9.08%
Limits
The federal direct loan limits for dependent undergraduate students depend on their year in school:
First-year $5,500
Second-year $6,500
Third-year and beyond $7,500
These direct loan limits fall laughably below the cost of education for many students.
Income-Driven Repayment
If someone’s total student loan debt is larger than their income, it may make sense to go on an income-driven repayment plan.
These plans can:
lower the monthly payment and
increase the chance of forgiveness.
Forgiveness
Opportunities for student loan forgiveness include:
Mercy after repaying on an income-driven plan for 20-25 years,
There’s even a chance student loans will be discharged at death. It’s a non-trivial reason to consider paying slowly.
Auto Loan
The average new car loan interest rate in the second quarter of 2014 was 6.34%, according to the Board of Governors of the Federal Reserve System.
The average loan length was about 5.5 years (66 months).
HELOC
Bankrate’s nationwide survey of large lenders reported that the average Home Equity Line Of Credit (HELOC) interest rate was 8.61% as of November 13, 2024.
Upcoming Expenses
A HELOC may provide options for a homeowner with significant equity who may have upcoming expenses.
Home improvements are a good example. The interest may even be deductible.
Early retirement is another good example. Home equity may be a better option than:
selling investments when the market’s down or
paying income taxes and possibly a 10% penalty for accessing retirement funds before age 59.5.
It can be easier to secure the HELOC before retiring. The lender will want to verify income.
Not a Loan (Yet)
A line of credit isn’t a loan!
It’s more like a credit card limit. Just because someone has one doesn’t mean they must use it.
Application
Applying for a Home Equity Line Of Credit is like applying for a mortgage. The home acts as collateral, which lowers the interest rate.
Terms
As with any loan, the terms matter.
The Consumer Financial Protection Bureau has this to say:
If you get a HELOC, you can generally spend up to your credit limit anytime during the borrowing period, also called the “draw period.” The draw period could last 10 years, for example.
After the draw period ends, you stop being able to borrow from your HELOC and enter the “repayment period.” Your lender may set a schedule so that you repay the full balance, often over ten or 20 years.
Mortgage
The Federal Housing Finance Agency (FHFA) reports the average outstanding interest rate at the time of origination was 4.2% as of the second quarter of 2024.
However, interest rates have risen. The average new 30-year mortgage interest rate was 6.78% the week ending November 14, 2024.
Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US, November 18, 2024.
Con: Future Flexibility
Although credit expands current options, it can limit future them in the future.
Future Options
If someone must pay for past purchases, they may not be able to:
take a big trip,
help out a family member, or
invest in a business.
Using credit now can reduce cash later.
Life Impacts
Debt can force lifestyle decisions. A couple may wait to buy a home until after their student loans are repaid.
The promise of Public Service Loan Forgiveness (PSLF) may convince someone to work for a government entity instead of accepting a higher paying private role.
Interest and fees constrain cash flow. Someone may have to work a higher stress job to pay off debt. Debt can even delay retirement!
Con: Credit Availability
Using some credit can improve access to credit. Using more can cause the opposite.
The reduction is one for one to start. Someone who:
uses $2,000
of a $10,000 credit limit
has $8,000 left.
However, taking on more debt can lower credit worthiness.
Lines of credit may be lowered or even cancelled. Falling limits reduce available credit faster than use alone.
It’s ideal to use less than half of the available balance on each account. Using more can worry lenders that someone’s struggling to pay their bills.
Con: Financial Risk
Growing account balances and falling credit limits is a dangerous combination. Higher charges, fees, and payments restrict cash flow.
Someone can get behind - or worse. Missed payments have an even bigger impact on credit score than higher utilization.
If this situation continues long enough, a borrower may need to seek creditor protections through bankruptcy.
What Americans Owe
72% of American household debt is for real estate:
70% mortgage and
2% Home Equity Line Of Credit (HELOC).
Auto and student loans each make up about 9% of the total. Credit cards account for about 6% of household debt.
Over 90% of household debt is home, auto, and student loans!
These data come from the Household Debt and Credit Report published by the Federal Reserve Bank of New York in the third quarter of 2024.
About 88% of debt is with predictable installment loans:
70% mortgage,
9% auto loan, and
9% student loan.
Student loan payments can vary based on income and other factors.
I hope this helps!
If you’re interested in a review of your situation…
Disclaimer
In addition to the usual disclaimers, neither this post nor these images include any financial, tax, or legal advice.
