Home > On Finance > In Debt

On Finance: In Debt

Please Note: This article is intended to help people who are planning for their financial future. It is most definitely NOT intended to help people navigate an existing financial crisis. It is not intended as a critique of those who have experienced a financial crisis. It is simply an attempt to pass on the lessons learned from so many others in order to help prepare us for the future events that will happen in one’s life.

This is the discussion about the final part of our financial stability trifecta — DEBT. Specifically consumer debt. As I wrote previously:

Debt is defined as a liability. In turn, a liability is defined as 1) the state of being legally obliged and responsible 2) indebtedness: an obligation to pay money to another party 3) the quality of being something that holds you back.

While all three are accurate for our purposes, definition #3 is particularly poignant when considering financial stability. Debt is perhaps the most critical aspect of one’s financial situation which will determine how quickly financial collapse happens. Once accepted, debt can not be easily reduced or managed. Payment or credit irregularities caused by difficult financial situations can quickly trigger punitive penalties and changes in terms which significantly add to the financial crisis. This often starts the downward spiral which is outside of the control of the individual.

I repeat those paragraphs because I believe they do a good job of summarizing the situation. No financial position is ever improved by having debt. It whittles away at an individual’s financial stability while pulling the rug out from under them when things get rough. How fast a financial problem spirals down into a crisis will be largely determined by how much debt you have. If you are in the middle of experiencing this effect then I am sorry for stating the painfully obvious, but these are good lessons to be learned for the future. With planning you will come out the other side. For those that haven’t been there yet, I am hoping you learn the lessons and avoid it.

I don’t believe there is such a thing as “good debt” for the majority of the population — the future will always be easier if you pay cash. However, I will concede that a properly structured mortgage (fixed payment, <30 years, <90%, straight amortization),for a reasonable sized house that you live in, is a reasonable use of debt . The many advantages of purchasing a house will usually, but not always, outweigh the downsides of the debt acquire it. I consider the purchase of a reasonable home to be one of the best vehicles to build financial security. Refinancing a home to pay off other debt is not a reasonable use of a mortgage and will always work against you.

Virtually all the other debt most person will use is what I would call “consumer debt”. For simplicity, I will define that as debts obtained for items or services which can’t reasonable be expected to maintain a marketable value above the total cost of the debt (principle and interest). Basically, it is consumer debt if you can’t sell whatever you bought and be able pay off the entire purchase price AND finance costs. For the rest of this article I will refer to “consumer debt” simply as “debt”.

The use of debt is virtually always a failure to live within your means or the failure to plan and prepare properly. I know that is harsh, but I find myself wanting to repeat it: The use of debt is virtually always a failure to live within your means or the failure to plan and prepare properly.

I can see everyone’s mouth starting to move to mention this exception or that exception. I’ll be harsh again and say “I’m sorry, I don’t buy it.” Car repairs are foreseeable (you WILL have them), you should have adequate health insurance, you can have funds set aside for the layoffs. With proper financial management you should be ready for most of life’s events before you put a new car in the garage, and/or buy a four thousand square foot house, and/or take that vacation to the islands. Prepare FIRST and THEN enjoy the excess if you must. When things happen before you are fully prepared you are almost always better off finding alternative methods of reducing or paying for the event.

Life, it is said, is what happens when you are making other plans. Some people do do experience severe catastophic crisis in their life. Some rare life events are simply too large for most to be prepared for. Planning will help, but it will take them a while to adjust and start again after such an event. These, however, are not what cause most people to fail financially.

It is helpful to keep in mind that failure can happen to the most effective of us — many existing self-made millionaires have previously filed bankruptcy for various business efforts that failed in their climb up the financial ladders. On the flip side, many millionaires of yesterday who lived high but failed to plan are going through personal bankruptcy today. Planning will always make it easier.These, however, are not what cause most people to fail financially. You pick yourself up and start again.

When talking about emergencies and credit I can’t but help but to recall the guy I read about in the USA Today newspapers. He was a self proclaimed “conservative spender” who only used his credit cards for “emergencies”. Over 14 years he had accumulated $70,000.00 dollars of credit card debt for “emergencies”! While I don’t think seventy thousand dollars over 14 years is unreasonable for emergencies (and interest), the fact that he wasn’t able to pay off ANY of those over 14 years, much less better prepare for them, gives me pause. His finances are clearly not in control. In the article he related that he wanted to discharge the debt through bankruptcy because he didn’t want to be saddled with it as he and his girlfriend were having their first child in April. The paper painted him as a victim of the credit card companies… I just can’t accept that. I will admit, though, that the credit card companies should have known better.

I haven’t always felt so strongly about this subject. Only recently have I become a hard core opponent of consumer debt. I used to think that there were items for which it was reasonable to use it. I thought convenience was a reasonable reason to use debt. Having watched the events of the past few years I no longer can reasonable justify that position. Debt is bad. NOTHING will more quickly take a difficult situation and make is hard, or take a hard situation and make it seem hopeless, than debt.

This is what changed my mind: As I watched the economic disasters of 2008 unfold it became obvious to me that it was largely caused by consumer debt. The financial crisis is simply the bill coming due for the past twenty years of debt-financed, excessive consumer spending. People decided they wanted to HAVE before they EARNED, to sell their future for the pleasures of today. They didn’t want to SAVE and PREPARE. They justified it all by assuring themselves that more credit would be there if they needed it. The government ACTIVELY urged people to save less and buy more on credit in order to keep the national economy appearing even better than it was (which got them re-elected). The saddest part is that the majority of this excessive spending was financed on the back of the nation’s home equity balances – the very asset which used to serve as the stabilizing foundation of personal and national economies.

If we don’t learn from the origins of the current crisis we are doomed to repeat it. You can learn from the past and have a chance to strengthen your own financial security, or you can cop-out and blame the people on Wall Street and leave your future to the whims of the world. Your choice.

Avoiding debt requires planning and preparation. There is no way around it. It requires passing by some of the things we want today so that we can have a more secure future. Sometimes that means extra hours at night working to have money to put aside. It might mean becoming a college student again to have a more profitable career. It might mean buying the smaller house in the area instead of what everyone else is buying. It might mean passing up your daily Latte for a coffee at home.

A final note (which will hopefully also become an article): Success should be measured against your TRUE values, not against your financial position. Having more does not mean you are more successful, it just means you have more. Sometimes is actually means you have less simply because you owe more.

Posted by Paul Gernhardt on Friday, January 02, 2009