Let’s state the obvious: inflation is high, a recession seems to be on the horizon and middle-class families are being hit harder than ever. For individuals and families who are already struggling or considering major life transitions, questions about debt and how to manage it are certainly front and center right now. Fortunately, 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. In practice, for most people, there are only two things worth tapping into and borrowing from: 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 vacations, luxury items, or second homes. Some families may need a second car, but in that case borrowing for a sports car over something reliable and more affordable is not a good use of debt. However, since homes and college education are usually quite expensive, many people will need additional funds in the form of mortgages or student loans to pay for them.
pay for education
When considering student loans, individuals should first ensure that they understand exactly how much their education will cost and what the quality of that education will be. Then they have to look for creative ways to pay for it. Could an employer cover some or all of the costs? What types of scholarships or grants are available? Is there a more affordable public school with a similar curriculum? Is a four-year degree required for a given career path, or could sufficient education be obtained at a two-year school? Alternatively, it is often more affordable to do two years at a community college and then transfer for the final two. Then they must take personal responsibility for their cost of living. Rather than covering all their expenses with loans, most people can and should work while in school to cover their costs.
Whatever difference is left, then, can usually be made up with government loans, but people have to be careful about the amount of debt they take on, the interest rates (these vary widely between different types of undergraduate or graduate student loans), and whether they expect the return on investment at that level to be worth it. Student loan decisions have to be made in the real world.
To buy a house
Besides education, the other investment worth going into debt is buying a home. The typical American probably doesn’t wait for interest rates to reach a certain level before making the decision to buy a home. Instead, when buying a home, they should first formulate a budget to understand if and what they can afford. This budget will have to take into account not only mortgage payments, but also utilities and taxes. If an individual or family can afford these costs, they should take out a mortgage to purchase their principal residence. If they can afford a 15-year mortgage with more favorable terms, so much the better. Most people may need a longer term of 30 years, and that’s fine too.
While an education and a primary residence are usually the only very good uses of debt for middle-class families, for some people it can sometimes be okay to use leverage for additional investments. In these cases, however, people need to think carefully about the costs and whether they can really afford them. Sometimes it can be a good idea to borrow for a second home, but only if you have the money in your budget to make all the necessary payments. and you think that the capital invested to buy the secondary residence would not generate better returns if it were invested, for example, in the stock market.
Likewise, for some people it may make sense to use leverage (debt, in other words) to invest in securities, but they need to be clear-headed about what will happen to the value of these securities if the market goes down and they are put under pressure. Will they have enough assets to survive a market downturn? This type of investing requires someone to really know what they are doing and understand the stock market. If you know what you’re doing, over time you’ll make money, but that’s not for most people and comes with significant risk.
Families today need to focus on budgeting, cut back where they can, and understand their responsibilities. Whenever possible, they should aim to keep only good debt and eliminate bad debts such as credit card payments wherever they can. It may not be fun, but it will make it easier for them to weather a recession and, in the long run, improve their financial well-being.
What steps are you taking to ensure your financial well-being in today’s economy? Share them with me on Twitter at @CoachJoeMoglia.