Borrow Only What You Know
You Can Repay
Our self-centered, debt-centered economy is like those electronic bug-zappers. They emit a light attractive to insects that blissfully fly right into the trap, only to be killed.
—Randy Alcorn
Given the number of people who lost their homes through foreclosure when the US housing market crashed, setting off the Great Recession, it would be easy to conclude that borrowing money to purchase a home is way too dangerous, fiscally foolish, and to be avoided.
We could take a similar stance on financing a car or taking student loans because automobiles depreciate and there are no guarantees of jobs for college grads.
We could flat-out ban borrowing money in our lives, but that would be like the proverbial throwing the baby out with the bathwater.
I am grateful for a home mortgage. Without it, my husband and I would not have had a prayer of owning our home. And I don’t believe that financing an automobile is evil or that all student debt is toxic. Rule 7 insures you have a safety net when borrowing money.
Borrowing money and the debt that creates should be taken on rarely, and then dealt with swiftly. Debt should be a means to an end. Borrowing money is a financial tool that improves your life if dealt with intelligently, not emotionally.
Rule 7: Borrow only what you know you can repay.
When I use the word “know,” I do not mean with absolute certainty beyond a reasonable doubt know. I mean to know as in having a reasonable certainty based on credible information. Another way to put it would be “borrow only what you have a reasonable certainty based upon credible information that you can repay,” which seems awkward. So let’s stick with “know” in this rule, knowing that we know what it means.
The only way that you can know with a reasonable level of certainty that you can pay off a debt is to have the means to do so in reserve. That goes for every type of borrowing, every kind of debt. This is so important, I am going to repeat it: the only safe way to borrow money is to have a means to pay off the debt in reserve.
The Trouble with Debt
Debt is not ideal. It’s not a prize you get for having achieved a good credit rating. Debt is something to be tolerated in certain situations and only for defined periods of time under rigid guidelines.
Dealing with debt is like owning a python. You have to know what you’re doing, always exercising a great deal of caution because if you slack off and lose control, it could strangle you to death.
When you incur debt, you make a rather arrogant presumption on the future. In effect, you’re saying that you don’t have the money to buy that thing that you want now—this could be anything from a house to a pair of shoes—but you assume you will have the money in the future to make payments. You presume that you will have a job, that you will have your health so you can perform your job. You presume that you will love whatever it is you went into debt to acquire as much as you love it now—and that it will not become obsolete or used up for as long as the debt remains—so that making the payments will not become drudgery. Acquiring a debt is simple compared to all that is required to carry and eventually pay off that debt. Simply making the promise to repay makes presumptions, and some of them quite arrogant, on the future.
Debt transfers future wealth to one’s creditors. No matter how much you may want to build wealth for retirement or to pass on to your children, it won’t be there if you stay in debt. Whatever you hope to have in the future, for yourself or others, already belongs to those who lent you the money to buy what you have today.
One estimate is that Baby Boomers (defined as those who were born between 1946 and 1964) stand to inherit $11.6 trillion, largely from their parents.[31] Those who have managed to land themselves in a deep pit of debt will experience the sadness I hear from so many readers—transferring what they hoped would become future wealth to their creditors to pay off a large accumulation of revolving debt.
Never forget that as hard as it is to make a living, it’s a lot harder to earn money that you’ve already spent.
Debt promotes discontentment. Debt is often what happens when you’re not satisfied with what you can afford to have right now. And once you start pursuing “more,” you’ll always be unhappy with what you have at the moment because, face it, there will always be something more out there that captures your attention. It’s easy to use debt as the antidote for feelings of dissatisfaction and discontentment. Then it becomes akin to drinking a glass of salty water. It makes you thirsty so you want to drink more, and the more you drink the thirstier you become.
Debt limits your options. This is true of any type of debt, even a secured home mortgage. Debt is like a lead balloon that holds you down in one spot. You have a legal obligation and no choice but to keep earning whatever you can to pay it off—even if the things that incurred the debt were wants or items long since consumed. Because you turned them into debt, the debt payment has become a “need” or essential expense. You have no flexibility to follow other dreams or any other call on your life, no matter how noble or godly. You have to pay your debts first.
The financial obligation incurred by debt can keep you chained to a job you dislike or living in a home that no longer meets your needs if due to market conditions you are unable to sell that home to pay off the debt. Debt can limit your options when it comes to a future spouse when you come chained to a load of debt your beloved simply cannot accept. It can remove options for where your kids will go to school or whether you can afford to have kids at all.
I could go on and on, but I think you get my point regarding how options can disappear in the face of debt.
Debt is expensive. No matter how you look at it, when you opt to go into debt to pay for a home, car, or any other thing you can think of—you will pay dearly for that dubious privilege.
Example: take a $200,000 home on which you have a $160,000 mortgage payable at 5 percent interest over 30 years. Your monthly principal and interest payments will be $859. Here’s what many people don’t think about: $859 x 360 = $309,240. Add the $40,000 down payment and you will discover that your $200,000 home really cost $349,240. And that’s at a fairly low rate of interest. How about a $1,500 engagement ring paid with a credit card at 22.99 percent interest under typical terms where the monthly payment is 4 percent of the outstanding balance? It will take 101 months (almost 9 years) and $1,175 of interest to pay it off, for a total cost of $2,675.
If you are ever tempted to buy something because it is such a bargain that you cannot afford not to buy it, but you don’t have the money so you must use credit, do this before you make your final decision: double the sale price. Is it still such a great bargain? Probably not, but that’s what it’s going to cost if you opt to pay for it over a long period of time.
A Safety Net Reduces Trouble
While it is always better to not have debt, at times it is unavoidable. So just like living with a python, you become masterful at putting safety measures in place. The stronger your safety nets, the less likely it is that you will be harmed by the debt.
When I refer to “safety nets,” I mean the guidelines and precautionary measures that are part of Rule 7. Those who throw caution to the wind, venturing into the world of consumer debt without safety nets in place (I include myself in those I am about to call foolish), have lots of scars to show for their foolishness. And it is not only the horrendous amounts of wasted money but also the myriad lost opportunities.
Here’s the bottom line: debt is not a good thing, and it is to be avoided whenever possible. When it cannot be avoided, debt should be entered into advisedly, with tremendous caution and a strong system of safety nets in place.
Three Categories of Debt
All debt falls into one of three categories: reasonable, toxic, and neutral.
Reasonable, or good debt, is the result of borrowing money to buy something that has a high likelihood of increasing in value, and in so doing will increase your net worth. Buying a home with a low-risk mortgage would be an example of reasonable debt because as the debt is repaid and the home appreciates in value, your net worth will increase proportionately. That is financially reasonable, without imposing an unreasonable financial risk for you, the borrower. A reasonably small amount of student loan debt can also come under the umbrella of good or reasonable debt, provided it meets certain criteria as described on the following page, because you have a reasonable likelihood of getting a better-paying job after you graduate than you would’ve without the education.
Toxic debt is exactly as the name implies: dangerous and financially life threatening. Toxic debt includes credit card debt, payday loans, and other high- or variable-rate borrowing. Toxic debt is deadly and should be avoided entirely. Toxic debt is not secured by collateral, and the interest rates are typically so huge they could choke a horse. If you have toxic debt, it needs to be paid off quickly (see chapter 13) and then avoided in the future by every means possible. I cannot state this too strongly: toxic debt is hazardous to your wealth.
Neutral debt includes all other borrowing that is neither good because it’s not going to increase wealth in any way, nor bad because it’s not exactly toxic.
With these definitions in mind let’s look at general guidelines for Rule 7 borrowing, followed by specifics for the different types of borrowing.
Safe Borrowing Guidelines
The following guidelines apply to all forms of borrowing—all forms of debt.
1. Borrow the least you can get by with to achieve your intended result, not the most that the lender will approve. Never let a lender determine how much you should borrow. Mortgage lenders will try to nudge you into the “most house you can qualify for,” not the house you can afford.
2. Repay debt quickly, rather than stretching it out as far as possible. Opt for the largest payment you can handle, not the smallest the lender will approve.
Auto lenders will try to steer you into a long-term loan of 60 to 72 months, pointing out that your payment will be smaller. This is great for them because dragging it out over a longer period of time with smaller monthly payments means you’ll be paying a lot more interest over the term of the loan. That adds up to a big payout for the lender, but it’s a lousy deal for you.
3. Have an escape plan. You need to have a plan in mind to pay off the debt early in the event life takes an unexpected turn, either by selling the collateral or paying the debt with other resources or assets.
Home Mortgage Debt
For a home mortgage to be a debt you know that you can repay, the principal owing should never be more than 80 percent of the home’s market value with a monthly payment that is no more than 25 percent of the borrower’s net income. Example: if the purchase price of the home is $250,000, you should borrow no more than $200,000 ($250,000 x 80% = $200,000). This creates a comfortable margin that will give you reasonable certainty that you can repay that loan either through the repayment schedule or by selling the property at market value and using the difference between the selling price (market value) and the balance to pay off the outstanding mortgage.
With the real estate housing crash and the Great Recession so fresh in our memories, it’s important that we talk about this matter of “underwater” mortgages, which means that for whatever reason, a borrower ends up owing more than the property is worth. At that point, the debt becomes toxic if there is not sufficient collateral to repay the loan upon the borrower’s whim. This is a critical point that every homeowner needs to anticipate by knowing with certainty where the market value of the home is in relationship to the amount owed.
The way to avoid falling into this kind of situation is to always maintain a healthy margin between the amount you owe and the home’s market value. By stringently adhering to the criteria that your outstanding mortgage principal balance should never be more than 80 percent of the home’s current market value, you’ll be in a safe position.
Each month as you make your mortgage payment you will increase the gap between the home’s value and what you owe, so that even if the market value fluctuates down you’re in a good position to keep your head above water, so to speak. Soon you’ll owe 75 percent, then 70, and then you will owe nothing and enjoy 100 percent equity. You will own that house free and clear, which is the intended purpose of having a mortgage in the first place.
A closer look at most “underwater” mortgage situations of the past few years would most likely reveal mortgages that were already close to, if not greater than, the home’s market value. Borrowers were able to buy homes with nothing down (100 percent loans), and in some cases lenders, for a fee, would lend more than the home’s market value, assuming that the value would appreciate and soon catch up.
Home Equity Loans
A home equity loan, curiously known in the industry as HEL, is typically a second mortgage that allows the homeowner access to the equity (that margin between what is owed and what the property is worth). Equity is the borrower’s asset—and a precious asset at that.
Theoretically a HEL is a secured or safe debt because it is collateralized by the home’s market value. Upon the borrower’s desire to repay the debt, the home can be sold to satisfy both the first mortgage and the HEL, also known as a second mortgage. Please do not miss the operative word “theoretically.”
A HEL can be very risky because it can so easily lead to toxic debt. There are five ways the toxic factor can sneak into an otherwise intelligent, safe mortgage situation.
Even taking into consideration the fact that the interest on the home equity loan may be deductible from your taxable income, the risks involved with this potentially toxic debt can be weighty.
The equity in your home is an appreciating asset, for many people their only appreciating asset. If you leave it alone, it will grow as the property becomes more valuable and as you pay down the first mortgage. That contributes to the safety factor of your home’s mortgage. To muddy those waters with an HEL opens the door to toxic debt.
Student Debt
Student loan debt best falls into the “neutral” category, as we categorize debt. And it walks a very fine line. Unsecured student loan debt can easily tumble off into the pit of toxic debt.
You will recall from chapter 1 that the total student loan debt outstanding in the US has grown to $850 billion, which exceeds the outstanding credit card debt, now standing at $828 billion. That’s huge and not a matter to be taken lightly. Untold millions of adults are drowning in student debt, which has become a worse problem for them than their credit card debt. Student debt, unlike credit card debt, cannot be discharged through bankruptcy. There is a fine line between neutral and toxic when it comes to student debt, and is something you need to consider very carefully before taking an educational debt plunge.
The biggest issue for me when it comes to borrowing money to pay for college is this matter of reserves. Where’s the money held in reserve to pay off the student loan debt? Theoretically that reserve is held in your ability to earn that money quickly upon completing school and landing a job in an industry that will welcome you and your degree. Something that would have been closed to you without that education. That’s the theory.
Now let’s talk reality. With 85 percent of college graduates returning home to live with their parents upon graduation because they cannot find a job,[33] I need to give a very strong warning when it comes to racking up student debt. Student debt always comes with a high level of risk due to the lack of collateral, but never higher than in this season of tremendous economic challenge facing the US.
First and foremost, if you are planning to get student loans, choose a school and major where there’s a demonstrated track record of return on investment. Law, medicine, nursing, and engineering are considered fairly safe bets as there are jobs in those fields.
Of course, if you can fund your education without any loans through scholarships, grants, and paying as you go, that will be the most ideal. As a general rule, public state colleges and universities and community colleges are cheaper than private institutions, which reduces your financial risk. If you feel that you absolutely must go the student loan route, you will have to create your own limits on how much you will borrow. The school will want to be very generous by offering everything for which you can qualify. Do not see this as some kind of prophecy that you will actually be able to make the repayments on all of the money you could be allowed to borrow.
To keep your student loan under the umbrella of “reasonable debt,” your total student debt (all four years) should not exceed the average first year entry level salary in the industry for which you are preparing. Check the “Student Loans Occupation Handbook” online at http://www.bls.gov/oco/home.htm/ to get an idea what your first-year salary might be. It is reasonable that you could repay your entire student debt within the first three years of your working career. That should be your goal.
While federal guidelines do not require borrowers to make any payments on their student loans until after they leave school, do not take that option. Instead, start making the small monthly interest payments as soon as you take the loan. This will preclude a negative amortization situation where the unpaid interest each month is added back into the loan as additional principal so that by the time you get around to paying off your loans (once you are out of school) you owe far more than you borrowed.
Let me give you an example. Let’s say that you borrow $5,000 in September of your first semester as a freshman, at an interest rate of 6.9 percent. Because of the terms of a student loan, you are not required to make payments until you leave school. But that doesn’t mean the interest is not owed during those years. In this example, the first month’s interest calculated at 6.9 percent APR (annual percentage rate) on $5,000 is $28.75 ($5,000 x .069 = $345 ÷ 12 = $28.75). If you do not pay that amount, in October your principal owing will be $5,028.75. You now owe more than you borrowed because the interest you did not pay became part of the principal. In November you will owe interest on the $5,028.75. This is called negative amortization. In November you will be charged 6.9 percent APR on $5,028.75, which is $28.91. If you do not pay it, it becomes part of the principal, and your debt will grow to $5,057.66. If you wait for four years and six months to start paying this loan, just imagine how much $5,000 will have become.
A better idea would be to pay $28.75 every month, while you are in school. When you finish school you will owe the original $5,000.
After you’re out of school for six months, you must begin to make monthly payments on your accumulated student debt (if you have been making at least the interest payments all along, you will owe far less than if you have been avoiding that). Do not give in to temptation to put your loans into forbearance or deferment. That only pushes the pain of payment farther into the future, while the unpaid interest keeps piling up. Put yourself onto a fast repayment track to get the debts paid off as quickly as possible.
Credit Card Debt
Credit card debt is flat-out toxic. If you cannot pay the entire balance every month before the due date, so that you are never paying interest, stop using the accounts. Give the cards to a trusted friend or relative who will hide them for you. It’s that serious!
If you are carrying toxic credit card debt now, determine that you will pay it off quickly (in chapter 13 I will show you how to do this quickly and effectively). There are few things you can do that will burn a hole through your discretionary income faster than paying double-digit interest each month for stuff you bought that you probably don’t even have any longer.
I want to show you just how toxic credit card debt can be. Let’s say that you are carrying a credit card revolving balance of $3,500, at an interest rate of 29.99 percent, and your minimum monthly payment is 4 percent of the outstanding balance. Even if you stop adding any new purchases to that account, it will take you 188 months (that’s 15.6 years!) to be rid of that debt. In that time, you will pay $5,429 in interest. Another way to look at it, $3,500 grows to $8,929 by the time you pay it off. That is the true cost of toxic credit card debt.
As horrific as the foregoing example is, it’s too kind for this reason: the typical person who carries this kind of credit card debt is not likely to go for 15.6 years without adding a single purchase. During that time, something will come up and the cardholder will slip just one more meal, another pair of shoes, or even a well-deserved vacation onto that account, turning it into a lifetime of toxicity.
Credit cards can be seductive with all of the rebates, cash back, and mileage points. The industry has done a great job at making us believe that carrying some toxic debt is not a problem. But it is. And it is very foolish to carry debt because you wanted to get the miles. Or to buy something on credit to get 2 percent cash back. It makes absolutely no financial sense to pay 29.99 percent on an item you can afford to buy outright because you wanted to get 2 percent cash back on the purchase price.
It takes financial intelligence and personal discipline to keep a credit card account active (see chapter 9) without allowing it to become a toxic situation. But millions of people do, and so can you. It requires discipline and a full understanding of how credit card accounts operate.
Automobile Debt
The only way to borrow safely to finance a car is to make sure its market value is always greater than the outstanding loan principal. Because cars depreciate, you need to save ahead for a healthy down payment, making sure you are borrowing the least, not the most, the lender will approve. Once your loan is in place, make it a race to get the car paid off faster than it is losing market value. The difference between what you owe on the car and the amount you could sell it for tomorrow afternoon is called “equity.” You want to build equity faster than you are losing value due to depreciation. Once you reach 100 percent equity, you owe nothing and that car is fully paid.
Here are guidelines to make sure your car loan does not turn toxic. Keep the payments to 36 months or less. If you stretch it out longer, you will pay far too much interest and you run the risk of paying for car repairs on a car for which you’re still making payments.
A car loan can contain elements of reasonable borrowing provided you make a large down payment, select a model that historically retains a high resale value, and pay it off in three years.
An automobile loan is a secured debt, which means that the car itself holds the reserves necessary to repay that loan. In theory you should be able to sell the car at any time to pay the debt. But here is the challenge to that situation: cars do not appreciate. Every day it loses value. Unless you are paying the loan faster than the car is depreciating, the debt can turn toxic.
Scripture on Debt
Given my history with credit and debt, I was surprised when I dug into the Bible to see what God has to say about borrowing money and going into debt. I expected to find the word “debt” synonymous with living a sinful lifestyle. Here’s a quick overview of what I learned.
Debt is not forbidden or condemned, although God discourages it by giving us countless warnings against getting into debt.[34] Those in debt are warned to get out as fast as possible.[35] Those who do not pay their debts are cursed: “The wicked borrow and do not pay, but the righteous give generously.”[36]
Debt is characterized as bondage: “The rich rule over the poor, and the borrower is servant to the lender.”[37] I sure know what it feels like, and it doesn’t feel good.
Lending money, on the other hand, is encouraged and seen as a good thing. God blesses those who have enough and are willing to lend to others.[38] It occurred to me that if, as I had assumed, borrowing money was evil, that would make those who lend accomplices, and that is not the case.
Borrowing money is not wrong, but it should be done advisedly and with tremendous caution. Debt of any kind should be seen as a short-term situation that always has an accompanying aggressive payment plan.
Debt should never be seen as ideal, but rather as a reasonable means to an end. Being debt free is ideal, and the goal for which you should be reaching with all the determination and strength you have.