Let’s Talk about Debt: Your Financial Frenemy

(Part 1 of a Series: A CPA’s Advice to Young Adults)

Stan Rose, Director, Tax Practice
June 2019

I don’t feel old enough (and my wife and coworkers would agree I certainly do not seem mature enough) to have a daughter graduating from high school, but that is the case. As she morphs from child to adult, I hope she is ready for what life will throw at her (and am curious to see whether the world is ready for what she will throw at it!). 

The thoughts below come from my realization that while they teach plenty of math, economics, and history; high schools and even colleges do not routinely teach financial responsibility. Young adults too easily are swamped at an early age with debt, and some never really learn to manage it even later in life, perhaps not because they are irresponsible, but simply because no one ever taught them how to handle their personal finances.

These thoughts have led me to begin a series of articles, written by a CPA to his daughter and others like her. Although directed toward young adults, it is relevant to people of all ages and stages of life. This installment will familiarize its readers with various types of debts, and arm them with a few tips that will help them choose and use loans, while keeping them in their place. Its goal is to help the reader develop good financial hygiene, starting with a healthy, but simultaneously uneasy relationship with debt.

Introduction

Loans are nothing more than a way to get something now that you will pay for later. Debt is a fact of life, but to avoid being unnecessarily burdened by it, we need to do two things: (1) Learn to distinguish which things in life are worth being saddled with loan payments, versus things that should wait until we have the funds to pay for them outright. (Loans are born from necessity on one end of the spectrum, impatience on the other, or anywhere in between.) (2) We also need to learn how to incur debt, because not all debts are created equal. Some types of debt are more costly than others, or have somewhat unfavorable terms. Others are simply too large relative to our ability to repay them.

Too often people struggle to acquire necessities and can barely make ends meet because they are continually paying off the loans related to previous acquisitions. There are exceptions, but school, housing, and transportation generally represent good reasons to incur debt, while some other uses are more frivolous, or should be delayed until your current earnings or savings can fund the purchase outright. Let’s address some of these uses individually.

Uses of loans – When should I get into debt?

Education

School loans make sense because they generally will allow you to land a job that will be rewarding and will compensate you better than would be the case without the degree. Most programs allow your first loan payment to be deferred until several months following your college graduation. However, rapidly-increasing college costs and easy access to loans have led to huge loan balances facing recent graduates – many of whom are still making payments many years after graduation.

To avoid getting in over your head, current and prospective college students first should aggressively pursue scholarships and grants. You also should give careful thought to the possibility that a less expensive state college, community college, or trade school often can provide a quality education and job opportunities on par with a much more expensive private college – and will allow you to graduate with a much smaller loan balance. Also, some careers tend to pay better than others, while others are rewarding in ways not measured by money (how much you are helping others, and how much you enjoy what you do, etc.). The key is choosing a career and a school that will not result in you overshooting your means to repay the loans.

This is asking a lot of an 18-year old student, and represents an area where lack of proper coaching by others (parents, teachers, administrators, lenders) has sadly let many students down. A number of politicians are proposing various ways that existing college loans can be forgiven. However, loans do not just spontaneously evaporate, and “forgiveness” sometimes is a masked way of saying that someone else will be forced to pay your debt (perhaps through increased taxes), or the lender will be forced to accept repayment of less than the amount owed. However, if you are going to borrow money, you, as borrower, need to accept the responsibility to repay it – do not assume someone else will pick up the tab. Do some digging into the compensation you are likely to earn in your chosen career, and run some math on how long it will take to pay down loans of various amounts. These should be big factors in decisions regarding your career and choice of school.

Car and home

Automobile and housing loans are unique because they are collateralized loans. Collateral is something that by agreement, the lender can take from you (by “repossession”) if you fail to repay the loan.

Housing loans (“mortgages”) generally are viewed as a good use of debt, because the value of real estate tends to increase over time. This means that if you buy a house and later sell it, you should receive enough money (and then some) to pay off the original loan. However, sometimes housing values decrease, yielding a potential sale price that is less than the original purchase price, and maybe even less than the remaining amount owed on the loan. Generally a bank will try to avoid this predicament by requiring you to make a “down payment” of cash for some portion of the purchase cost, and lending you the rest. Many years ago, a 20% or more down payment was standard, but in recent years, as little as 5% or even less is required, depending on the lender. Before making the loan, banks will attempt to verify that you are likely to be able to make the payments, but do not rely on their analysis. You, rather than the lender, are responsible for not biting off more than you can chew. Even if home values rise, that increase does you no good until/unless you sell, and you should never buy a home so expensive that you cannot easily make the payments.

    Observation: “Starter home” is a term for a first home that a buyer believes he or she will sell down the road when the time, personal income, or expanding family headcount are right for a larger home. Everyone needs a place to live, but unlike renting, owning a home is an investment. Buying small, while paying down your mortgage and (hopefully) watching your home’s value increase, is a great way to play good defense with your money.

Automobiles, unlike homes, lose their resale values quickly, and for that reason, you should always make modest choices if you must borrow money to buy a car. Get something safe, reliable, and affordable, and save the “status” car for a time when you are on stronger financial footing.

Furniture/toys/vacations

There may be exceptions, but it generally is not advisable to incur much debt to acquire personal property. Obviously, if you buy a home, you will not care to sit on the floor, and will need some furniture. If you have furniture, and are considering an upgrade, consider waiting until you can afford to buy it outright rather than borrowing money to acquire it now. The same could be said for recreational items, like snowmobiles or boats.

Not that long ago, vacations were more widely viewed as a poor use of borrowed money, because unlike homes, cars, or even snowmobiles, which generally are available for your use throughout the length of the loan, vacations are fleeting – they come and go very quickly. This does not mean necessarily that borrowing money to fund a vacation is a mistake, but those who are destined to make prudent financial choices throughout their lives would concede that some things should be acquired only when you can truly afford them using money you already have, and these categories are a good place for you to learn some financial discipline that will pay off for the rest of your life.

I likely will ruffle feathers by taking this a step further and suggesting that weddings perhaps should be scaled back or delayed until they can be paid for without borrowing. Not to belittle the celebration, but the wedding is over before you know it, and it is the marriage itself that is far more important and (ideally) lasts for a lifetime. Be sure you determine it is worth it before you and your spouse saddle your young marriage with a large debt right out of the gate.

Conclusion

Debt is a fact of life these days, and can hardly be escaped. But debt can either be used by you, or it can control you, depending on your choices. My hope for young readers is that they learn to put debt in its place, working for them, rather than the other way around. That can be achieved sometimes by luck or strong wages, but is best accomplished by careful thought, planning, and frequent exercise of patience and restraint.

Next in our series we will address how to choose one loan over another, once you have decided the use of debt is in order.

To discuss with the author, or complain how his call for financial restraint is raining on your parade, please contact Stan Rose at 800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.