Abacus: Debt And Its Undesirable Necessity

Siriporn Kaenseeya / EyeEm

Many young people read about personal finance topics from a variety of sources, with a myriad of authors, websites, and news programs offering advice on a number of aspects of money management. Whether it be choosing a suitable retirement plan, deciding which types of insurance are appropriate to purchase, or contemplating how many credit cards to apply for, many people can be overwhelmed by the guidance provided by so-called experts and gurus in the financial services industry.

One particular feature that is routinely lambasted by such professionals is debt, an obligation that must be paid off. To a large extent, the criticism surrounding the idea of one getting into debt is rightful: the interest on certain loans can compound to such a high degree that the amount owed on specific contracts is exceedingly high. Moreover, those who do not owe money can instead use cash flow in other, more beneficial ways, such as by storing money into an investment account that accrues interest in their favor.

But financial obligations operate to a very high extent in the way most humans oversee their personal circumstances.

For many people, owning their own home looms as a large personal and financial objective. Without having access to debt options, accomplishing such a task can serve as very daunting, more so than it already is for a lot of people. This feeling is especially severe for those living in high-cost of living areas, where typical home prices can range in the several hundreds of thousands of dollars, with nice neighborhoods being home to million-dollar properties.

To better provide hard-working people with the ability to overcome such a constraint, banks and other lenders issue mortgages, loans that can be used to purchase a variety of real estate assets. When utilized to achieve respectable goals, and when used with careful-decision making with regards to the projections of one’s future financial situation, debt can be employed as something of an aid, rather than serve as a source of stress and detriment.

Whenever someone considers taking out a loan, they should always ask themselves whether the cost of doing so outweighs the potential benefit that comes with what they’re trying to accomplish. A classic instance of someone spending too much for the value they’re receiving occurs during car shopping: automobiles are known for depreciating quickly in value. Indeed, according to data from Carfax, the value of a new car can decline by more than 20% after one year, followed by subsequent annual declines of as much as 10% over the next four years.

With the mean car price standing at $36,718 as of May 2019, it would be smart to purchase a car that is only a few years old in order to strike a balance between price and mileage.

Consider that an auto loan of a new vehicle priced at $30,000 with a 5% interest rate over a 60-month term requires monthly payments of $566. If, however, a user bought the same model car but allowed for its initial value to decline, say, 40% over its first four years, that same monthly payment plan would necessitate payments of $340.

Such calculations can be applied to all types of liability contracts. In the case of mortgages, which, depending on one’s scenario can be deemed to be either “good” debt or “bad” debt, it is important that one considers a number of factors before purchasing a home.

In particular, a good rule of thumb to follow in accordance with financial advisors is that total living expenses should not exceed 30% of one’s pre-tax income. By such logic, someone earning $70,000 in gross income should spend no more than $21,000 on housing, and someone earning $40,000 should allocate a maximum of $12,000 on similar expenses.

This rule plays a significant role for many people in deciding whether to rent or buy a particular property. Typically, one should choose to rent if the costs of doing so (the fixed rental income, as well as any utility bills and insurance) do not exceed the costs of owning a place (the potential mortgage and interest payments, as well as any utility bills, taxes, insurance, and maintenance costs).

For homes that cost several hundreds of thousands of dollars, the amount that one pays in interest can seem especially intimidating, especially in comparison to other loans.

Contemplate that the median home price in New York City in August was about $654,000. Assuming a 20% down payment is placed on a similarly valued home, a 30-year mortgage associated with a historically normal 4% interest rate would entail monthly payments that sum to more than a million dollars, a dollar amount nearly twice as high as the loan itself.

Such a scenario should go to show that, even for debts that can be considered “good” and worthy for one’s financial future, one should always examine all of the features connected to a particular liability. The hefty amount that people can pay on mortgages is a big reason why many financial planners stress the importance of securing certain fundamentals for those looking to shop for homes, such as having a relatively high paying job, as well as owning sufficient savings and high-growth orientated investment accounts, like retirement funds.

While payment plans may unnerve many working-class people, debt in itself has served as a necessity in many functions of life. Although one should clearly do their best to stay out of dangerous situations, like accumulating high-interest debt on a credit card used to pay for consumption goods, various people in society view debt as something that can be taken advantageous of.

Though credit cards can be a cause of stress for those with spending problems, they can play an opposite role for those who are more frugal and have a stable financial background, as a history of paying off financial obligations can serve as a means to achieve a high credit score and earn better future opportunities to receive loans with relatively low-interest rates.

On a more macro level, financial institutions can view debt in a positive light. A company looking to expand its ventures may be more inclined to go into debt rather than issue shares of equity, as debt has the advantage of allowing a firm to know how much they will pay a lender in future periods while issuing equity can potentially decrease future profits.

The lessons that debt options can teach a society should not be discounted. Whether someone is in high school or is well-established in their career, or even is chief executive officer of a Fortune 500 company, they should review all of their options before deciding upon a debt instrument.

A teenager who comes from a low-income background should perhaps think twice about taking out a loan valued at tens of thousands of dollars to attend an expensive school when they could instead consider a more economical option, and a working adult should think hard about whether they should amortize their housing costs rather than remain a renter.

Falling victim to the lures of quick money can lead to devastating effects on one’s financial foundation, whereas a precise and thoughtful evaluation of one’s intentions can lead to better decision-making all around.