We’ve often heard from the banks and financial institutions that the key to getting rich is managing your debt responsibly. Debt, after all, is as much a part of modern day life as driving a car or tapping on a smartphone. It’s just the way things are.
And part of that conversation is the differentiation between “good debt” and “bad debt.” To recap, “good debt” is defined by the Financial Industry as debt that is used to buy something that goes up in value. Common examples given are a house or education. Meanwhile “bad debt” is defined as debt used to buy something that goes down in value. Credit card debt is the most obvious case.
And while we can all agree that credit card debt screws you over, isn’t it suspicious that those very same Financial Institutions that warn you that “credit card debt is bad debt!” will then turn around and sign you up for as many credit cards they possibly can? Why is that?
Because the banks are right about one thing: Debt IS the key to getting rich.
Think about this. Banks love to tell everyone what a wonderful investment real estate is. Housing always goes up, up, up after all! You can’t lose when it comes to real estate! If you don’t buy in now, you’ll never get in ever and you’ll be caught sitting on the sidelines missing out on the easy gains everyone else will get! It’s relentless. You can’t walk into a bank branch without having mortgage papers thrown at you.
So here’s my question: If real estate is such a sure-fire great investment, why don’t the BANKS buy it for themselves?
After all, they have the money. They ARE the ones giving out mortgages after all. If real estate is a surefire win, then they should want it for themselves rather than lending you money to buy it.
Here’s why: The Banks are lying to you.
Real Estate is NOT risk-free. Real Estate has gone south before, and will go south again. And when it does, the banks don’t want to be the ones losing money. No, they’d rather have someone else take the risk while they still get to reap the rewards.
How do they do this? Debt.
But not by taking on debt themselves. They do it by talking YOU into taking it on instead.
Because as we’ve demonstrated, when a homeowner takes on a mortgage to buy a house and that house goes up, all the fees, commissions, and interest payments the homeowner must pay to cash in on their investment eats up most of the price gains (up to 95%, in the example scenario we discussed in a previous article). In fact, the bank came away with one of the biggest slices of the pie (25%, second only to the slimy real estate agent who got even more). The homeowner was left with only 5% of the gain.
So when the homeowner wins, the bank wins. But what if the homeowner loses? What if the house doesn’t increase in value, stays flat, or even declines? Well, the bank certainly doesn’t lose money. The homeowner may take a haircut on the value of their home, but that value comes right out of their equity. The debt remains, and the homeowner has to keep paying their mortgage payments even if the value of their home is LESS than the value of the mortgage! And if they stop paying? They lose everything when the bank forecloses on their house. Whoever owns the debt always wins.
Now many people have written to us already with some form of debt, asking whether their situation is OK or not. In a perfect world, nobody would owe any debt, because as soon as you owe someone money, you are naturally their bitch and have to do what they tell you. But the world isn’t perfect, obviously. And besides, many people have debt from years ago before they ever came across this blog, so we can’t exactly yell at people for something they did years in the past. So to answer the question of “how much debt is OK?” we use a general rule to calculate that number.
First, take your monthly take-home after-tax pay. Then, subtract off your monthly living expenses (pick a typical month without any one-time spikes like car repairs or whatnot). Multiply by 12. This is your ammo box.
Why do I call it your ammo box? Because this is the amount available to you each and every year you may use to murder the fuck out of some debt. So for example, if you’re a couple and together you make $100,000 after tax, and you spend $50,000 a year on living expenses, then your ammo box is $50,000 a year. That’s how many bullets you have to shoot at your debt.
So how much debt does this translate to? Well, it kinda depends. Specifically, it depends on each debt’s interest rate. Remember those old arcade games where you and a bunch of your friends would beat up an end boss? He’d fall down, everyone would cheer, but then the boss would just flash and re-appear twice as big and four times as angry. A debt’s interest rate is kinda like that. The higher a debt’s interest rate, the faster it grows as you’re trying to shoot it. So the higher the interest rate, the more dangerous it is.
So to measure how dangerous a debt is, we simply calculate how long it will take you to kill it. If a debt grows really fast because it has a high interest rate, we want to be able to kill that thing immediately because if it starts to grow, it’ll very quickly become a snowball that will crush you. If a debt’s interest rate is more manageable, we can take on more of it because it’s not as dangerous.
Generally, the maximum amount of any debt we recommend for anyone is 5 years worth. That means whatever your yearly debt-killing ammo amount, multiplied by 5. Why 5? Because that’s the typical length of a mortgage term. Also, it’s the amount of time we Millennials stay in (or get laid off from) the same job, on average. Our Boomer parents had the luxury of getting a job and counting on it to pay them for decades, but those days are long gone. So any debt that takes more than 5 years to kill is idiotic and dangerous, since our jobs don’t last that long.
But back to the types of debt. What types are debt are there and how much of each is safe to hold?
Consumer debt is credit card debt, lines-of-credit, payday loans, that sort of thing. Anything with an interest rate > 10%. This debt is, no surprise here, bad Bad BAD! An acceptable level of consumer debt is 0. Yes, ZERO. Anything above that should be treated as a financial emergency, because it is. It is impossible to build any wealth with consumer debt hanging over your head. Every bullet you have and every bullet you can spare should go into killing this as quickly as possible. Murder with extreme prejudice.
Student loans are a little better, since they don’t accrue interest while you’re in school and Student Loan interest rates generally aren’t as bad since they’re backstopped by the federal government. The current student loan in the USA for undergraduate degrees is around 5% – 7%. At that rate, a reasonable amount of time spent killing this debt is 3 years. Any more and you run the risk of running out of job before running out of debt.
I have some fairly harsh opinions about mortgages, but as far as loans go, mortgages are generally the lowest interest rate debt you can get since it’s secured against the value of your house. Current mortgage rates for a 5-year fixed term as of 2016 are around 2-3%. This debt is fairly safe since the interest rate is fixed for the 5-year term, but once that term is up it will renew at whatever the prevailing interest rates are, and not you, me, or even Fed Chief Janet Yellen can accurately predict where interest rates will be in 5 years. So at maximum you should plan on killing this debt within 5 years.
But but but…
And I know. I know. Killing your mortgage in 5 years is not what the banks tell you to do. You’re supposed to pay that thing off in 25 years, not 5. And the reason they’re telling you that is because they’re trying to hand you enough rope to hang yourself with. They know that your job won’t last 25 years, and they don’t care. They want you to buy more house than you can afford so you can run into trouble later, default, and then they can take your money, plus your house! It’s win-freaking-win! Except, you know, for you.
The reason why we came up with these numbers is because, and we know you might be surprised when we say this, but we don’t trust our jobs to be stable, and we sure as HELL don’t trust the goddamned banks. 5 years of debt slavery under a single mortgage term where they can’t arbitrarily change the interest rate on you is about as much risk we would ever be willing to take, and 5 years of staying in a single job is as much stability that us Millennials can ever count on.
So for our example couple who has an ammo box of $50,000, their maximum safe mortgage amount is $250,000. So take a minute and calculate your own personal safe debt level, and if you’re below these limits, great. You have the Millennial Revolution’s stamp of approval on your debt levels. But if you’re at or above these limits, you are officially over-leveraged.
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