In part 1 of Understanding Debt, we discussed credit card debt, student loan debt, payday loans, financing a car, and personal loans. This time, let’s take a look at four more types of debt:
1. Medical debt
Medical debt isn’t sought out. Instead it typically results from an unexpected medical emergency. The best way to avoid medical debt is with sound preparation. Having a health insurance plan that fits your situation is a must. People often tell me they can’t afford health insurance, and my response is always “you can’t afford not to have it.” You can make a bad financial situation much worse by not having health insurance. It is easy to accumulate a $100,000+ bill when involved in a medical emergency. Insurance is there to insulate you from those huge bills. You also need to have an emergency fund to cover deductibles or copays as well. Also, having a baby is expensive (typically around $15,000). I know many people who are “paying off” their child, which seems ridiculous, but is actually quite common. If you know the baby is coming you need to do everything you can to save money. That may mean taking a second job or temporarily stopping retirment savings. Having a baby is not an emergency, so you should plan for the medical costs.
2. Home equity loans and HELOC
This is one I get asked about a lot. A home equity loan is often used as a consolidation loan. There is nothing naturally evil about a consolidation loan. There can be problems with them however. The first is that you are leveraging your most important asset, your home. If something happens where you cannot pay it back, you could lose your home, and that’s a large risk to take. I have worked with many clients who have consolidated debt in the past. Two years later, they are contacting me with debt problems again. According to Cambridge Credit Corp, 70% of Americans who take out a home equity loan or other type of loan to pay off credit cards, end up with the same amount of debt (or more) within two years! That’s a pretty sobering statistic. While debt consolidation can work, it’s certainly not an automatic problem solver; if you do it you need to do it right. I have often seen that taking out a consolidation loan gives people the feeling that they fixed something without addressing the root of the problem which is usually overspending and not living on a budget.
A home equity line of credit (or HELOC) also falls under this category. The only reason to have a line of credit is to cover overspending. A better plan is to not overspend (now there’s a novel idea)!
3. Unsecured bank loans
The major problem I see with unsecured loans is that they usually comes from overspending as well. “I need money fast and don’t know where else to get it.” Usually, an emergency fund or saving up to buy a large ticket item will make an unsecured loan unnecessary, and is a much safer way to ensure you are buying stuff you can actually afford. Plus, it takes all the risk out of having a loan.
Finally, a kind of debt that I don’t have a major problem with. Although I would ideally like to see someone buy a house with cash, it’s not typically feasible because of the large amount of money involved. That said, it is extremely important to buy a house you can actually afford. My wife Mandy and I found this out the hard way as we sold our first house in order to move into something more in tune with our budget. I recommend buying a house where your payments will be 25% or less of your take home pay – based on a 15 year (or less) mortgage. Why? If you take out a loan for $150,000 with a 3% interest rate, you will pay $77,666.90 in interest over 30 years. If you take out a 15 year loan for the same amount, you will only pay $36,459.76. That is a huge difference, and when more than 25% of your pay goes toward your mortgage, it’s near impossible to accomplish other financial goals. Another must is to put 20% down at closing. Doing so will help you avoid private mortgage insurance (PMI), which is basically just money down the drain. One final rule: base all of these numbers on one income, even if you’re both working. You never know what will happen when kids enter the picture. Even if you both plan on continuing to work, living on one income is always a good idea! In fact, Mandy and I had to sell our first house because we based what we could afford on both our salaries. Once our first baby arrived and we decided Mandy would stay home, which through all our budgeting numbers out the window! If start living on one income but both continue to work, great, now you’ll have more money to give, save, live your mission!
These are obviously just my thoughts on debt. I will say however that they don’t just come out of thin air. They’re based on facts, personal experience, and the experience of working with clients who have had these types of debt totally ruin their lives – and to me, the debt just isn’t worth the cost!
What are your thoughts?