Let’s state the obvious: Inflation is high, a recession appears to be on the horizon, and middle class families are getting squeezed worse than ever. For people and families who are either already struggling, or are considering some major life transitions, questions about debt and how to handle it are surely front and center right now. Thankfully, there are few rules of thumb that can help anyone trying to manage and use debt effectively.
“Good” Debt Versus “Bad” Debt
The first thing people need to know is that not all debt is the same. As a practical matter, for most people, there are only two things that are worth leveraging and worth borrowing for: your education and buying a home. Good debt takes the form of an investment in yourself and your family. Financially responsible people will avoid borrowing money for a vacation, luxury items or a second home. Some families may need a second car, but in that case, borrowing for a sports car versus something reliable and more affordable is not a good use of debt. However, since homes and college educations are typically quite expensive, many people will need additional funds in the form of mortgages or student loans to afford them.
Paying For Education
When considering student loans, individuals should first make sure they understand exactly how much their education will cost, and what the quality of that education will be. Then they need to look for creative ways to pay for it. Could an employer cover part or all of the cost? What kind of scholarships or grants are available? Is there a state school that’s more affordable and offers a similar program? Is a four-year degree required for a given career path, or could a sufficient education be had at a two-year school? Alternatively, it’s often more affordable to do two years at a community college, then transfer for the final two. Then they need to take some personal responsibility for their cost of living. Rather than covering all of their expenses with loans, most people can and should work while they are in school to help cover their costs.
Whatever difference remains, then, can typically be made up with government loans, but people should pay attention to how much debt they’re taking on, what the interest rates are (they vary considerably between different types of undergraduate or graduate student loans), and whether they expect the return-on-investment at that level to be worth it. Decisions around student loans need to be made in the real world.
Buying A Home
The other investment besides education that’s worth taking on debt for is buying a house. The typical American is probably not waiting for interest rates to reach a particular level before making the decision to buy a home. Instead, when buying a home, they should first formulate a budget to understand whether and what they can afford. This budget will need to take into account not just mortgage payments, but also utilities and taxes. If an individual or family can afford these costs, then they should take out a mortgage to purchase their primary residence. If they can afford a 15-year mortgage with more favorable terms, great. Most people may need a longer term of 30-years, and that’s fine too.
While an education and a primary residence are typically the only really good uses of debt for middle class families, for some individuals it may at times be correct to use leverage for additional investments. In those cases, though, people need to think carefully about the costs and whether they can really afford them. Sometimes it may make sense to borrow for a second house, but only if you have the money in your budget to make all of the necessary payments on it, and you believe that the principal invested to buy the second home would not generate better returns if it were invested in—for instance—the stock market.
Likewise, for some individuals, it may make sense to use leverage (debt, in other words) to invest in securities, however, they need to be clear-eyed about what will happen to the value of those securities if the market goes down and they’re put under pressure. Will they have enough assets to survive a market downturn? This sort of investing requires that someone really know what they’re doing and understand the stock market. If you know what you’re doing, over time, you will make money, but it’s not for most people and carries significant risks.
Families today need to focus on budgeting, cutting back where they can, and understanding the liabilities that they have. As much as possible, they should seek to only have good debt and to eliminate bad debt such as credit card payments wherever they can. It may not be fun, but it will make it easier to weather a recession and in the long-run will improve their financial wellbeing.
What steps are you taking to ensure your financial wellbeing in today’s economy? Share them with me on Twitter at @CoachJoeMoglia.