The theory of “good debt” really started before the Great Recession, and generally applied to student loans and mortgage debt. In those days it was easy to assume the value of a home would appreciate, at least keeping pace with the interest rate, and the equity consumers were building justified paying the interest. Like a financial zombie, that myth just won’t die — and it continues to shuffle through conventional thinking, even though these days the theory is getting a little shabby.
The fallacy is that home prices will rise to keep pace with the interest rate and inflation. In some areas over very specific times, that’s certainly true. If you bought a home in the San Francisco Bay area two years ago, it has trounced the return on any other investment you made; not by a little, but by a lot. Applying that type of cherry-picked example to investing is like looking at casino billboards featuring the big winners and thinking you can beat that return. But most real estate markets have not matched that performance — and a house is still the worst investment the average person makes in his or her life, a fact that stands up to historical scrutiny.
What About Student Loans?
I think it’s amusing that economists bemoan the fact that young people, just out of school and saddled with student loans, aren’t borrowing money to buy homes and cars. So, because they have one type of debt, they’re not taking out another? That makes no sense, and shows just how far the concept of debt has taken hold in our financial lives. When it comes to student loans being worth it, the answer is “barely” and that calculation is a moving target. The cost of school is rising nearly three times faster than the rate of inflation, and the calculation has already moved far enough that college is not for everyone anymore, and not every major is worth it. Going to school part-time, taking the first two years at a community college, and taking a break to work are all strategies to consider for lowering the overall amount of debt you take on chasing a college degree. Some extremes are a bridge too far; even I would say a little student loan debt is better than living in your car. Don’t live in a van.
A False Sense of Security
The whole concept of good debt is built on the availability of low-interest loans. Retail interest rates of 3%-5% have skewed the math, and make debt seem more palatable. What that mental calculation overlooks is the opportunity cost of borrowed money. Let’s say you borrowed $10,000 at the average interest rate for a used car, which according to HSH is around 4.5%. Not only will you end up paying $945 in interest at the end of four years, hoping your used car makes it that far, but you missed out on returns you could have made investing the same car payment over four years at a very conservative stock market return average of 6%. Starting with $1,000 down and investing $188 a month for four years at 6%, you end up with $11,723 dollars. That’s enough to go out and pay cash for a functional used car. If you bump the amount you pay every month to $260, you can raise nearly the same amount of cash in just three years.
A Glimmer of Hope
The good news is that Americans have started to catch on that there’s nothing “good” about credit card debt. According to Gallup data published on CreditCard.com, a lower percentage of Americans is relying on credit cards than in 2001, and the percentage carrying a balance has dropped from 41% to 33% during the same time frame. Usually, at this phase of the discussion, someone jumps in bragging about the fat cash back checks they get from credit card rewards. If you’re one of the 64% that pays your balance in full every month, you can play that game — and come out ahead. But miss one payment, get sick, lose your job, and all of a sudden you’re stuck with a big bill and maybe even a higher interest rate. While there may be rewards, there are significant pitfalls.
Every financial situation is different so, before you buy into that tired old conventional wisdom about “good debt,” do the calculations and talk through your options for avoiding going into debt. Many times you can discover an alternative to borrowing money, or at least minimize and delay what you do end up borrowing. Whatever you do, don’t kid yourself that the debt you do take on is somehow good.