Afraid You'll Be in Debt Forever?! Why You Don't Need to Be Debt Free
Chances are, you’re in debt. And you aren’t alone. 80% of Americans have debt and are in the same boat as you. Many of these people also fear that they will be in debt for the rest of their lives. But I’m going to let you in on a secret about debt.
You do not need to fear being in debt because being in debt is not necessarily a bad thing!
Yes, you heard that right! Having debt does not mean you made a poor financial decision. It also does not mean that you now must strive to become debt-free. Someone who isn’t in debt is not smarter, or better with money than you are.
This is a very unpopular opinion in the finance community, so if you think I’m crazy for saying this, I can assure you that you are also not alone in that regard. To help you understand my thinking and set aside your fear of debt, I’m going to break down how debt works, how you can use it to propel yourself to the next level, and give you my 2 steps for calculating whether or not you should use debt to finance a purchase.
How Debt Works
Before you can understand why debt isn’t your worst nightmare, you need to know how debt works.
Debt refers to money that you owe. When you use debt to finance a purchase, a lender will loan you the amount of money you need to make your purchase, and then charge you a specified rate for using their money. This additional charge is called interest. Loaning money to people and charging them interest on the loan is how lenders, usually banks, make money.
You may be wondering how banks have so much money that they’re able to loan it out. Great question. When you deposit money into your bank account, your bank doesn’t actually keep that money reserved in a special safe for you. Instead, they lend it out to someone else, so that they can make more money from it. While this may sound like a crazy concept to you, this is no different than you making the choice to invest your money rather than save it.
Having an emergency savings is super important, which is why banks have reserve requirements. This is the amount of money they are required to hold in their vault at the nearest Federal Reserve Bank. That’s their emergency savings. Just like you should invest to make more money after you have an adequate emergency savings, banks want to do the same. They do this by lending.
How to Use Debt to Propel Yourself to the Next Level
While I am firmly in the camp that doesn’t think you need to be debt-free to be financially healthy, I do think there are ways to use debt that will benefit you, and ways that will hurt you.
Like we discussed previously, banks use loans to make money. Their goal when lending to you is to make as much money as possible with the lowest risk possible. They do not care about how the loan will affect your financial situation. I repeat, BANKS DO NOT CARE HOW A LOAN WILL AFFECT YOUR FINANCIAL SITUATION. If you meet their risk vs return criteria, they will lend to you.
Now that we’ve established that banks do not have your best interest at heart when lending to you, but are instead focused on how they can make money, it’s important to make sure you also intend to make money whenever you decide to take out a loan.
To help you better understand how to do this, let’s take a look at who wins and who loses when you take on the worst type of debt there is, credit card debt.
When you carry a balance over for more than 1 month on your credit card, you are in credit card debt. When you use a credit card to finance your purchases there are 3 parties involved.
- The Credit Card Company
- The Merchant (the store you purchased from)
- You
Now let’s determine who the winners and losers are in this situation.
1. The Credit Card Company
Credit cards have some of the highest interest rates around. The average interest rate on a credit card is 18%!! Charging you this insanely high rate allows credit card companies to receive higher returns from your credit card debt than from any of their other investments. That means they earn more money from the credit card interest you will pay them than they get from the other types of loans or investments they make.
Winner or Loser? WINNER
2. The Merchant
When you make a purchase with a credit card, your credit card company pays the merchant upfront for your purchase and then bills you for it at the end of the month. Unless you pay them back in full, they then charge you interest on this “loan”, which we already know makes them a winner in this scenario. Since the merchant received cash for your purchase from the credit card company, they’re also happy with how this transaction went down. They don’t care who pays them, as long and they’re getting paid.
Winner or Loser? WINNER
3. You
Now you may think that you’re also a winner in this scenario because you got the item that you wanted, but I have some bad news for you. If the store had told you when you were checking out that you actually had to pay 18% MORE than the sticker price for the item, you probably would have been pissed and walked out of the store. But that is exactly what is happening every time you make a purchase on your credit card and don’t fully pay off your balance. You just end up paying more for the things you buy than they’re worth.
Winner or Loser? LOSER
In this example, you can clearly see that the credit card company wins because they can make huge returns from your purchases if you don’t pay them off immediately. The merchant wins because they get paid in full for your purchases, and you lose because you just end up paying more money for all of your purchases.
Whenever you decide to make a purchase with a loan, it is important to evaluate all parties involved in the transaction and determine who will make money from the transaction, and who will lose money. If you’re the loser, DO NOT MAKE THE TRANSACTION!
Now let’s take a look at an example of how to make debt work in your favor and become a winner in a debt transaction. We’ll use the most demonized loans of all, student loans. Let’s say you’re 18 years old, you can’t afford to pay for college out of pocket, and you haven’t been able to secure any scholarships, so you start looking into your options for student loans. If you take out a student loan, what parties are involved in the transaction?
- The Lender
- The School
- You
Now, who are the winners?
1. The Lender
The lender will end up making money off of the interest you pay on your loans.
Winner or Loser? WINNER
2. The School
The school will be paid in full for your tuition by the lender.
Winner or Loser? WINNER
3. You
You will make an average of $1M more over your lifetime, qualify for jobs that pay higher salaries, and have more opportunities for advancement with a college degree than without one.
Winner or Loser? WINNER
Getting a college degree propels you to a new level that you would have had a much harder time reaching without it. Even though you end up paying more for your tuition if you take out a loan, thanks to interest, the interest you pay will most likely be far less than the increase in your future earning potential. While there are some caveats to this like you have to actually get the degree, some degrees offer higher earning potential than others, and you need to avoid taking out an excessive amount of loans, student loans are a great example of how to use debt as a tool that helps you reach new heights.
2 Steps to Evaluate if You Should Use Debt to Finance a Purchase
The two examples we looked at previously were pretty simple, but in the real world, it’s usually more complicated to evaluate if you’re actually the winner or the loser in a transaction and if you should use debt to finance your purchase. These 2 steps will give you the tools you need to evaluate whether taking out a loan is the right move for you in any situation.
1. Calculate the money out
The first step is to calculate all of the money you’re going to spend on the asset you’re purchasing. These expenses include the following.
- purchase price of the asset
- interest you will pay over the life of the loan
Let’s take a look at these in an example where you’re considering buying a house for $200k with a 30-year mortgage at a 3.5% interest rate.
- purchase price – this is the total price you are paying to buy the house including closing costs, and any renovations you will be funding with your loan. In this example, $200k
- interest expense – this is the total amount you will end up paying in interest until you pay off the loan. In this example, the total interest expense after 30 years will be $123k
Total money out = $200k + $123k = $323k
2. Calculate the money in
Once you know the total amount you’ll end up spending on the asset, you need to calculate how much money you can make off of the asset. To calculate this, you need to estimate the following.
- future selling price
- income generated over the life of the asset
Let’s take a look at these further by continuing with our home buying example.
- future selling price – this should take into consideration the current value of the home ($200k) plus the appreciation you expect over the next 30 years. Appreciation is an increase in the value of an asset. Homes are an example of an asset that usually appreciates or increases in value. The national average annual appreciation of homes is 4%. Assuming your house appreciates at 4% every year for 30 years, the future value of the home will be $648k.
- income generated over the life of the asset – In our example, you are planning to live in the home so it won’t generate any income. Examples of how assets can generate income are the rental income you would receive by renting out the home or the revenue generated by a machine you purchased for your business that makes products you can sell, etc.
Total money in = $648k
Now that you know your total spend (money out) vs your total revenue (money in) you just need to make sure the money in is greater than the money out.
From our example.
- Money out = $323k
- Money in = $648k
$325k WINNER!
Looks like you’ve got a winner! Assuming you can receive a 4% annual appreciation on your home, you will end up with an asset that is valued at $325k more than you paid for it. The additional $132k in interest may seem like a lot of money, and it is, but not when you compare it to the amount of money you estimate you will make in the future.
And there you have it! You shouldn’t fear being in debt for the rest of your life! As long as you’re using debt to finance purchases that will propel you forward and give you opportunities to build wealth, you’ll be in a healthy financial position, and can rest easy knowing that debt can’t stop you from becoming a rich bitch!
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