It’s true that debt is a four-letter word. I can count the letters in the word to prove that, or simply look to my dark financial past to conclude that debt can be most troubling.
Still, the truth remains that not all debt is created equal, nor is every type of loan hazardous to your wealth.
There is a world of difference between a say a home mortgage and revolving, high-interest credit-card balances. While both are liabilities in which a borrower is legally obligated to repay a lender, the first is a good example of what I call intelligent borrowing; the latter is just stupid debt.
Here are the five characteristics of intelligent borrowing:
1. The borrower has a way to escape—a legally and morally sound alternative to get out of the obligation at any time.
2. The debt is secured. The lender holds something that is at least as valuable as the amount of the loan. This is called collateral. Think of it as a security deposit for the lender.
3. The loan is for something that has a reasonable life expectancy of more than three years as opposed to something that will be down the drain before the bill arrives.
4. The loan is for something that will increase in value, unlike a couple of movie tickets and dinner in a fancy restaurant or great new outfit.
5. The interest rate is reasonable. The best example of intelligent borrowing is a home mortgage. As of this writing, the average rate for a 15-year fixed rate mortgage is 3.84%, while the average credit card rate overall is 17.55%. Wow.
Let’s see how a home mortgage measures up to each of these five characteristics of intelligent borrowing.
Is there a safety valve or escape route?
Yes, there is a sure way escape route for both the borrower and the lender.
If you the borrower finds that you just can’t handle those high payments or you want out for any other reason at all, you can sell the house, repay the lender and walk away free and clear.
If you are the lender and want out of the loan, you have the legal right and ability to sell that loan to another lender.
Is the debt collateralized?
Yes. With a home mortgage, the real property (land and structure) is the collateral—the lender’s security. The lender has a legal lien on the property until the mortgage is paid in full. If you do not hold up your end of the bargain the lender may take the property as payment for the outstanding loan.
Does the purchase have a reasonable life expectancy of more than three years?
Yes, and this is true not only for the structure itself but also for the land on which it sits.
Will it increase in value over time?
Yes. Real estate is considered an appreciating asset even though specific values may decline during economic cycles.
Is the interest rate relatively reasonable?
Yes. In nearly all situations, mortgage rates are considerably lower than other types of consumer loans, sometimes by as much as two-thirds.
Now ask each of these questions about unsecured debt and the answer will be NO, five times over. Unsecured debt is is anything but intelligent. Credit-card and other personal type signature loans are considered unsecured or non-collateralized debt.
Unsecured, mostly credit-card debt nearly destroyed my life. And repaying all of that debt—every penny without seeking any concessions or bankruptcy—gave me a new life. It took 25 years to get back to point zero (12 years to create the debt, 13 years to repay it more than $100,000 unsecured debt), a journey I would not recommend to anyone. Still, I am grateful beyond words because out of that has come a 100% debt-free life for my husband and me.
As you design your plan to get out of debt, target the stupid debts first. Don’t devote money to prepaying your mortgage (paying more than required) if you are carrying stupid debt from month to month.
Your home mortgage—your intelligent debt—should be the last debt you repay.