What Is Debt?
Debt is defined as “a loan that obligates the borrower to make periodic interest payments and to repay the full amount of the loan by some future date” (Gitman et al.). Another financial education resource defines it as “the lending of funds in return for periodic interest payments and the repayment of the principal debt obligation” (Dalton et al.). Debt can be used to finance life goals such as home purchases or education. While there is debt considered “bad” there are reasons why some debt is “good” and we will take a look at those now.
Financial experts state that debt can be good or bad. Good debt consists of two components: 1) relatively low interest rates and 2) the expected “life” of the asset is much greater than expected debt repayment period. An example of good debt would be student loans for an education linked to a profession such as engineering, teaching, accounting, medicine, or law. Debt obtained for the purpose of pursuing a degree for a profession that will lead to earning a stable income (or greater income) is considered “good” debt. Another example of good debt is a fixed-rate 15-year mortgage for a home purchase. It is highly likely that the house will be a useful asset longer than the 15 years it takes to pay off the mortgage.
In both examples, interest rates are relatively low and the economic life of the asset is greater than the repayment period. A degree for a profession will be used much longer than the typical 10-year repayment plan period just as a house is expected to last longer than a 15-year mortgage amortization schedule.
“Debt can be used wisely when used to purchase items that go up in value and when entered into extremely cautiously with substantial financial margin to protect against loss.” – Joseph Sangl
Bad debt is associated with loans that have 1) relatively high interest rates and 2) the expected economic life of the asset is less than the expected repayment period. For example, if an individual finances the purchase of a car for a repayment period of 72 months and the expected life of the car is only 60 months than this purchase would be considered “bad” debt. Another example is credit card debt. Often purchases made with a credit card are not expected to last longer than the repayment period of the credit card statement. This is due to card holders only making minimum payments on balances rather than paying the balance off in full each month it is due.
“Bad debt is things like automobiles, furniture, vacations, clothes, jewelry, entertainment, etc…. These all depreciate in value over time.” – C. Pete Benson
Before applying for loans, consider whether the debt will be good or bad based on the interest rate applied and the life of the asset that will be obtained through the purchase.
“Remember, it’s more about discipline than it is about dollars.” – C. Pete Benson (Benson, 2017)
“Debt is spending tomorrow’s money today.” – Joseph Sangl (Sangl, 2009)
Financial professionals have created ratios that can calculate how much debt a person can handle based on their specific financial situation. These ratios include the housing ratio, the housing plus debt ratio, and the debt to assets ratio. These ratios can calculate an affordable monthly house payment, an affordable house payment along with any other current debt, as well as a portion of assets that are financed.
The Housing Ratio
The housing ratio can calculate what an affordable house payment would be. By using your monthly housing costs and dividing them by your monthly gross income, you can find your monthly housing ratio. This ratio shows well an individual is spending too much on their housing costs. For example, if an individual has a housing ratio of 40%, they are spending too much of their income on housing. As the formula below shows, an individual or family should spend less than or equal to 28% of their income on housing costs (Dalton et al).
The Housing + Debt Ratio
The housing ratio determines the percentage a person is spending on their housing costs and compares it to the 28% benchmark. The housing and debt ratio uses the housing ratio and adds the amount of debt payments being made to show the percentage an individual is contributing to all of their debt payments. As the formula shows, a person should allocate less than or equal to 36% of their income on housing and debt payments. This means that their rent or mortgage payment + credit cards + medical bills + student loan + car payment should only be 36% of their entire income (Dalton et al). This ratio is a great tool to determine if an individual is carrying too much debt.
Debt to Total Assets Ratio:
The debt to total assets ratio reflects what amount of assets is financed with debt. The younger a person is the higher the debt likely is due to establishing themselves in the early stages of life like purchasing their first car and having student loans for college. Therefore, young adults tend to have higher ratios even as high as 80% while those close to retirement age likely have ratios closer to 10% due to the amount of debt that have eliminated by that point (Dalton et al). So, just remember as a young adult, the percentage may be high, but that is expected and manageable.
Real debt management isn’t through a company you’ve seen on television or heard on the radio. Debt management starts with knowing your debt and having a solid plan to reduce it! If you don’t have a formal budget you are following, you need one. It will be your road map to the destination of being debt free. “Good debt management is 80% behavior and 20% head knowledge” (Dave Ramsey). That simply means it’s easy enough for anyone to do, but you have to change your behavior to make it happen. Watch Dave Ramsey discuss the debt snowball method.
“Sometimes the pathway to being debt free is creativity, and many times it’s about grit, hard word and sacrifice.” – C. Pete Benson
Helpful tools for debt management
Download Amortization Chart Excel File
The amortization chart is customizable per loan so that you can see how making extra payments toward principle will help save you a lot of money in interest as well as help you get out of debt faster. It’s simple to use!
Resources & References
Benson, P. (2017). From Failure to Financial Fitness.
Dalton, Michael A et al. Fundamentals Of Financial Planning. 4th ed., Money Education.
Gitman, Lawrence J et al. Fundamentals Of Investing. 17th ed., Pearson.
Sangl, J. (2009). What everyone should know about money before they enter the real world. NIN Publishing.