If you watch financial planning segments on television, or if you listen to them on the radio, one of the most frequent pieces of advice by the show hosts is that you should pay off your debt. The most prominent TV personal advice person, whose initials are S.O., is now largely retired and living in the Caribbean. She was a strong advocate of paying off debt. On the radio, the most current advice advocate, whose initials are D.R., strongly criticizes, and almost berates, people who go into debt in order to live beyond their means. My question is: Is their advice correct? Is it always correct to pay off your debt?
Eat Your Vegetables
Advising someone to pay off their debt is the equivalent of telling someone they need to eat their vegetables. They know they need to do it, but they don’t like the sacrifice they need to make to do so. Overweight people know they need to lose weight by cutting back on high-calorie foods and eating more vegetables. Indebted people know they need to stop spending so much. In fact, it may be more difficult to pay off debt than it is to lose weight. People get into debt because they make $100 but spend $120. If they cut out spending the extra $20, they are just breaking even, and not paying down their debt. They need to spend only $90 or even $80 to actually pay down their debt. Cutting their spending from $120 all the way down to $80 is a 33% cut in spending. That’s a difficult thing to do and one reason why paying off debt is so difficult. It means saying “no” to eating out, parties, event tickets, travel, and a lot of other fun things. It may mean living a monastic life, if only for a short time. This is very difficult for young people, or for anyone, for that matter. I speak from experience.
Credit Card Debt
Another problem is that debt is expensive. Most people, when they go into the “debt spiral”, do so using credit cards. Credit card debt is expensive! Even during this low-interest-rate era, where the US Government can borrow for a 10-year term at rates barely over 2%, credit card issuers still charge interest in the high teens for unpaid credit card balances. That is great for the issuers’ gross margins but bad for those who carry outstanding credit card balances from month to month. Using my earlier example, if someone saves $20 of their $100 paycheck, some of that $20 will go to pay past sins in the form of credit card interest.
Auto loan debt is not bad in and of itself. It is bad for you if you are using a car loan to buy a car that you really can’t afford. Nice, expensive cars are very appealing and a status symbol especially here in the US of A. Car companies and auto dealers plaster the airways with car ads, even during Christmas! Anyone can afford the latest German import, right? Well, no, they can’t. Don’t forget to figure in the insurance cost. To their credit, the car companies have greatly improved quality over the years, meaning that repairs are less frequent. At least that is some good news. It is very difficult not to give in to temptation and buy a nice car that you can’t afford. Car loans are ok and pretty reasonable if you buy a car that you really can afford.
The problem with student loans is that new graduates don’t start off their working careers with a clean slate. They start off already in the hole. Think long and hard before knowingly going to a school that will necessitate that you (or your child) borrow a lot of money to go there. The rates and repayment terms may be good but the debt may force you in a direction that you don’t really want to go. This is a whole other blog topic.
The housing market is in much better shape now than it was in 2007, at the start of the financial crisis caused in part by subprime home lending. Population and family formation has grown since 2007 and the housing stock has not kept pace, meaning that demand exceeds supply right now. Because of high costs and other building restrictions, it is highly unlikely that builders will overbuild over the next several years. This is good news and bad news. The bad news is that home prices are high and likely won’t be coming down, while wages remain stagnant. It is difficult to find a house to buy that you can afford. The good news is that, once you are in and you own your home, and you can actually afford the payments and upkeep, the home probably won’t lose value and become “underwater” on the mortgage, which was the situation during the financial crisis. As with auto loans, the home mortgage is ok as long as you can afford the payments. If something goes wrong, at least you can probably sell the house and get out clean.
Don’t overspend. Live within your means. Don’t buy too nice of a car or house. Don’t go into credit card debt if you can avoid it. Go to community college and State U, or to a trade school, if it would otherwise mean you need to go into deep debt to go to the University of Private. Don’t step off into the debt spiral. Eat your vegetables.