Not all debts are created equal, nor is every type of loan hazardous to your wealth. There is a world of difference between a home mortgage and a revolving credit-card balance. While both types of debt are liabilities in which a borrower is legally obligated to a lender, the first I call intelligent borrowing: the latter is ridiculous debt because it is toxic to your financial health and your life.
Here are the characteristics of intelligent borrowing:
1. The borrower has a safety valve—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 a great new outfit.
5. The interest rate is reasonable.
The best example of intelligent borrowing is a home mortgage. 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 way of escape for both the borrower and the lender. If you find you just can’t handle those high payments or you want out for any other reason at all, you can sell the house and pay the lender. The lender can sell the loan to another lender.
Is the debt collateralized? Yes. With a mortgage, the real estate or house 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.
Ask each of these questions about credit-card debt and other kinds of unsecured debt, and you will understand why it is anything but intelligent.
As you design your plan to get out of debt, target the toxic debts first. Don’t devote money to prepaying your mortgage (paying more than required to reduce the principal more quickly) if you are carrying toxic debt. Your home mortgage—your reasonable debt—should be the last debt you repay.