Good Debt and Bad Debt

Well, my last post about debt being your single priority was about as exciting as it gets around here!

I know the post came across as blunt, hard-headed, opinionated, presumptuous, and a perhaps even a bit mean.

I hope (?) I also managed to get a few of you to question some deeply-held assumptions. That was my goal. The comments were fairly evenly split, which means I might have just about nailed it! 😉

Two themes emerged from your fantastic comments:

1. What about mortgage debt?
2. Then more generally, what about “good debt?”

Regarding mortgage debt, I answered in the comments that we paid off our mortgage in 2010. It was a big goal of mine from the time I was 23, my hair grew very long as a result, and I actually ended up owing the IRS money for a few months (I don’t recommend this). I’ll probably write a whole post about this. If you’re interested. Just let me know in the comments.

Good Debt, Defined.

I feel like there are a few ways we can assess whether debt is “good” or “bad.” We all recognize that rules are meant for exceptions, so please see these as…guidelines worth considering. I feel pretty comfortable putting them out there.

1. What is the return on the purchase that has been financed?
2. How much debt is begin assumed?
3. Why?

If you’re purchasing something that goes down in value, it’s bad debt.

I think this is a pretty solid definition. Homes don’t normally go down in value. Especially if you’re going to stay in the home for a long while.

A college degree doesn’t go down in value, though you need to be very careful here. Whether the numbers fall in line with your life’s passions or not, many industries and areas of study do not give much of a “return” on that debt you’ve assumed.

I was speaking with Adam, our Chief Product Officer, and he and I both share a lot of enthusiasm for the whole two-years-at-a-junior-college-then-transfer strategy. I also love state schools. Be crazy about scholarships.

Follow your life’s passion, balanced by a vice-like grip on your wallet. And my heavens, use YNAB for free while you’re a student.

My gut feeling is that the student debt load is not just a reflection of unbelievably sky-high tuition costs. It’s also, to some degree, a reflection of spending that hasn’t been checked. There are stories of students living the high life while on loans, and then stories of students that barely eked by, worked their way through, etc. Be one of those “barely eked by” students. 🙂

Stuff that goes down in value

That bison burger I just ate? That went down in value. The Disney(!) vacation you just went on? That went down in value. Any vacation goes down in value.

(But Jesse! The memories are priceless! Yes, but financed vacations don’t have a corner on priceless memories.)

I’m struggling to find something you purchase on a credit card that doesn’t go down in value. Cleats for my three boys for soccer… My little girls jeans… dinner last night… that reupholstered chair in the front room…

I like this definition. If you’re purchasing something with debt that goes down in value, that’s bad debt.

A new car’s value drops like a rock. A pretty used car’s value doesn’t drop nearly as fast, but it’s still inevitably headed south.

Can the amount of debt make it bad debt? I think so

The two items we just talked about above, those that hold or increase their value over time, and therefore should be good debt, the idea of a home and a higher education…

Can those become bad debts because of their size?

I think so.

Can a “good” debt like a mortgage become bad?

This is where you see rules of thumb come into play. A popular (though not always achievable if you aren’t really being creative) guideline is a 15-year mortgage at no more than 25% of your take-home pay.

Another rule of thumb to keep good debt from going bad is that no more than 1/3 of your take-home pay should be dedicated to mortgage and utilities.

I’ve recently been reading a book, The Not So Big House. They don’t have a square footage requirement, but they do have a guideline that every room of your house should be used every day.

(Then there’s the Tiny House movement. Julie calls it $30,000 tent living. The book I read called for 200 square feet per person. I think there’s a balance to be struck, but also love when people challenge conventional wisdom and buck wildly entrenched trends, like the trend of square footage increasing steadily for the past seventy years.)

This is all, of course, dependent on where you live. Regardless of where you live, you’ll want to pay careful attention to our third guideline when evaluating whether something is good debt or bad debt.

Why?

If you’re taking on a student loan, why? Why for that particularly expensive school? Are there any other (even off-the-beaten-path) options?

If you’re purchasing a home, why in that more expensive location? Have your assumptions around a location been checked, and re-checked?

What about the size of the home? One commenter mentioned in my last post that I must not have any financial regrets. I have several. One was spending $65,000 and nine months on software that I then completely scrapped. Another was purchasing the home I now live in. (I also regret planting 11 fruit trees, a raspberry patch, an asparagus patch, and a strawberry patch, because now it’s going to be even harder to downsize ;))

Here’s one for-instance. Julie and I like entertaining, so we were certain that we needed a dining room. We bought this house with a dining room and guess what else you get with a house that has a dining room? A bigger great room, kitchen (no regret there, I like the large kitchen), an extra bedroom, a larger basement, wider staircase, wider hallways, ridiculous master bedroom… the list goes on. All because we were convinced we needed a dining room. That means there’s more to clean, paint, fix, furnish, decorate and maintain.

That dining room has been used maybe ten times in the six years we’ve lived there. I don’t have any math to back me up, but I think that dining room cost me about $150,000. I’m no longer an accountant, but the “per party” cost is at about fifteen grand.

Recognize that I’m being a bit tongue-in-cheek here, but completely honest with you about my regret. Julie and I didn’t do a serious analysis of our true priorities and it led to assuming more debt than needed. The debt still fit okay into our budget, so it wasn’t really bad debt I guess, but it could have been better.

So back to guideline two, where the amount of debt can morph it from good into bad, you really need to work through guideline three, where you ask yourself why again and again, and really get to the brass tacks of your needs and situation.

Conclusion

These guidelines feel pretty good. If what you’re financing goes down in value, it’s bad debt. You can take on some good debt, and make it bad by assuming way too much of it. Finally, ask yourself why all the time, and be brutally honest with yourself.

P.S.

A few things have come of my somewhat incendiary post from earlier:

1. I plan on moving my family into an apartment to test the idea of happiness as it relates to living quarters with seven people (some of them rather small people, but large and loud voices). Julie said she’s good for a test that lasts three months. This isn’t a “real” downsizing test, because we know our home will be available when we’re done, but I think it will at least give us some insight into what it would be like to live in a much, much smaller space. This will probably happen in early 2015. Fall is too busy to orchestrate a move. Well, I’m too lazy to orchestrate it.
2. I increased our giving to help fund scholarships at the School of Accountancy at BYU (my alma mater). That’s one way to help students avoid student loan debt. A few people were really concerned because I didn’t distinguish between debt, and student loan debt. To be clear, I really don’t like student loan debt but can’t pretend to know everyone’s situation.
3. I’m not going to eat out for sixty days. I’m two days in. Some people really balked at my idea of not eating out. I’ve grown pretty used to eating out. I eat out for lunch four out of five days, probably. Julie and I go on a weekly date and it almost always involves a tasty restaurant. So this is coming from a guy that has a pretty solid habit of frequenting restaurants. I’ll make two exceptions to this: 1) If it’s a legitimate business lunch, where someone invited me. If I invite someone to meet up, I’ll avoid making a meal of it. 2) If I’m traveling and staying in a hotel. If I travel and have access to a kitchen, no eating out.
4. I really enjoyed writing, and have made myself the sole blog contributor again. (With the exception of a few posts here and there from our Teachers.) Be prepared for many, many more commas. I was told I don’t use them, correctly.