Unsecured debt will rob you of future wealth. Learn what types of debt can help you build wealth and how to use them wisely.
If you’ve spent much time at all reading and researching personal finance, then you’ve heard the name Dave Ramsey. Dave is the OG of personal finance. He has built a mammoth empire of books, podcasts, seminars, radio shows, events, and more.
The first thing you’ll notice in Dave’s teachings is that he HATES debt. If you call his show and ask him how to solve a problem, you know he will never suggest going into debt. The one and only exception is the 15-year, fixed-rate mortgage with a 20% down payment.
Hating debt is almost religious for Dave Ramsey. I understand his position. A few decades ago he ran up a couple million in real estate debt and went bankrupt. Ever since, he has made it his mission to help others avoid his mistakes.
I respect that.
However, teaching people to avoid debt completely and at all costs, is similar to Abstinence-Only sex education. I understand the sentiment, but if you don’t give people access to information about safe sex then you’re going to end up with a lot more unplanned pregnancies and STDs.
So, here is how I would amend Dave’s teachings:
Yes. Avoid debt if at all possible.
However, if you must go into debt, there are only three types of debt to consider: Real Estate, School, and Cars.
And, if you are going to use debt, learn how it works so you can use it wisely.
Your goal should be to build wealth and have a positive net worth. Unsecured debt (personal loans, credit cards, IRS debt, payday loans, and installment loans) simply reduces your net worth.
How to Use Real Estate Debt
Owning a home can be one of the best financial moves of your life. It offers two giant benefits: stabilizing housing costs, and increasing wealth through equity.
So, if you had been a renter for the last 30 years, you would have seen a steady increase in the cost of housing. But, if you had bought a house in 1990 with a 30-year mortgage and made the minimum payments, you would have just paid it off! So, now you have no mortgage payment and a house that has almost tripled in value since you bought it. Nice!
There are so many benefits that come with home ownership that sometimes people throw caution and logic out the window.
Yes, in general it is financially better to own a home than to rent. BUT, buying too much house, at the wrong time, with too little down, and when you have a bunch of other debt is a terrible idea.
Here’s why: owning a house can be a big financial win. But, losing a house to foreclosure will wreck your finances for years.
Okay, maybe that’s a bit dramatic. But, it is also true that if you buy too much house and don’t have enough room in your budget to take care of maintenance, repairs, plus live your life, then owning a home can really suck.
So, when it comes to debt on your home (AKA your mortgage), there are two major things to keep in mind: 1) don’t fall for the ‘how much do I qualify for’ trap, and 2) cash-out refinancing is almost always a bad idea.
Do Not Fall For the ‘How Much Do I Qualify For’ Trap
When you start shopping for a house, you will very likely end up asking a mortgage professional “how much do I qualify for?” It is a totally reasonable question. It is important to know the maximum they are willing to lend you so that you’re not shopping for houses that are impossible for you to buy.
However, the answer they give you is NOT the same as what your budget SHOULD be for your house. As I discussed in this article about 2 Budgeting Rules to Add FIRE to Your Finances:
“When the lender tells you how much you qualify for, they are answering the question: how much can they give you, based on your current financial situation, and expect you to be able to pay them back on time every month?
“But, the question you should be asking yourself is: how much should I spend on housing… so that I can keep myself in excellent financial shape?”
If you don’t know the answer to that question, then you can use a rule of thumb: 20 / 3 / 15. Put 20% down, don’t spend more than 3-times your current annual gross pay, and keep the payment less than 15% of your monthly gross pay.
By following the 20 / 3 / 15 rule, you know you will have room in your budget to keep the house running and live your life. Nobody likes to be “house poor!”
Very Little Good Ever Comes From Cash Out Refinancing
If you have owned your home for a few years, you have been making the payments, and you put a reasonable down payment, then it is possible that you could qualify for a “cash-out refinance.”
Basically, a cash out refinance is just a new loan for a larger amount than your old loan. The new loan is used to pay off the old loan plus you get a check for whatever is left over.
This can be incredibly tempting. There is cash just sitting there in your house, begging to be spent.
However, taking cash out of the equity in your home is almost always just a financial step backward. You have been making your payments diligently and are starting to make progress on paying down your mortgage. Then… WHAM… you cut up your old mortgage and replace it with a new, larger mortgage. And, worse, you start the 30-year payoff countdown timer all over again.
Any dream of living without a house payment just got that much farther away and harder to achieve.
There are very few circumstances where a cash-out refinance is a good idea… Possibly a remodel? But, never just to blow the cash on a vacation or car or whatever else. It is a much better and more sustainable plan to just save up for your big purchases and pay cash.
Sure, it will take longer. But, you won’t go broke and lose your house to foreclosure either.
How to use School Debt (AKA Student Loans)
Notice I said “School” and not “Education”. Do not use debt to finance the “college experience”. If you are not paying cash for your education, then make a budget, stick to it, and keep the costs down. Continuing your education beyond high school is an investment! That means that the more you pay for it, the lower the rate of return.
There are a ton of ways to keep the cost of college down and help you keep your student loans small. Attend a public university in your home state. Start at your local community college. Live with your parents while in school (or live off campus). Work at a paying job while going to school. Finish as quickly as possible.
Most importantly, make sure your plan does not include more debt than you can pay off within two years of graduation using the added income you can expect as a result of having the degree.
Check out this article for a primer on how to pay for college.
How to use Car Loans
The third type of loan that can sometimes be a good idea is a car loan.
Just like mortgages and student loans, car loans are over-used and abused all the time in the US. Just because you can get a car loan does not mean you should get a car loan.
Here is the car loan rule of thumb to remember: 20 / 4 / 10.
Put 20% down. Take a loan for no more than 4 years. Payments should be no more than 10% of your gross pay.
If you find a car that would require you to break any of those rules to purchase it… then find a different car.
Financially, car loans are a bit more difficult to justify than mortgages and student loans.
A mortgage is backed by an asset that is almost always increasing in value. If you run into trouble, you can generally sell your house and pay off most (or all) of your mortgage.
A student loan is used to gain skills that should lead to higher income. It is riskier than a mortgage because you are required to pay the loan back even if you don’t graduate or get a higher paying job.
Unfortunately, a car loan is backed by an asset that is constantly decreasing in value (often faster than the loan is getting paid off). So, if you get into trouble, you can still sell the asset and pay off most of the loan… but you may need to come up with some cash out of pocket to get out from under the car. Of course, most people who are trying to get out of a car because they’re in financial hot water don’t have a stash of cash laying around.
That’s why I am even more careful when deciding about a car loan than a mortgage or student loans. It is true that a car loan is secured, so you get a lower rate and if you get into trouble you can sell the asset and wipe out most or all of the debt. That is what makes car loans slightly better than credit card debt. But, they should be used sparingly and carefully.
My best advice on car loans is to experience what it is like to not have one. Keep your car for long enough to pay off the loan. Then, keep it for at least a few more months and see how freeing and wonderful it is to not have a car payment. Once you’ve tried it, it is unlikely you will want to go back.
Debt can be a powerful tool. But, it is also the most significant thing standing between many families and wealth.
Yes, get a mortgage and buy a house. But be wise about it and don’t make yourself house poor.
Yes, utilize small student loans to help get an education that will boost your income. But be sure you can pay off your loans within 2 years of graduation.
Yes, it’s okay to have a car loan sometimes. But, just because you paid off your car doesn’t mean it’s time to trade it in.
And finally, never have any other type of debt. No credit card debt, title loans, signature loans, payday loans, furniture loans, ATV loans, Rent-to-Own agreements (which are just expensive furniture loans), a loan to your mom, your kid, your brother, your grandma, or any other kind of debt.
I hope this has been helpful! I welcome your comments with your thoughts and questions. And, don’t forget to subscribe to the newsletter to get notified whenever a new article is posted.