2
Intelligent Borrowing, Toxic Debt
The only thing worse than investing in things that depreciate is paying interest on things that depreciate.
Blaine Harris, The Four Laws of Debt-Free Prosperity
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. Both are liabilities for which you, the borrower, are legally obligated to the lender. The first I call intelligent borrowing; the latter is toxic debt.
Those who are living debt-free and are debt-proofing their lives would sooner poke toothpicks under their fingernails than live in the grip of toxic debt. If they incur debt of any kind, it is only through intelligent borrowing.
Intelligent Borrowing
Intelligent borrowing means that some level of safety and limited risk for both the lender and the borrower are built into the transaction. Here is what intelligent borrowing looks like:
1. The borrower has a safety valve—a legally and morally sound way 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 obsolete before the bill arrives.
4. The loan is for something that will increase in value, unlike a great new outfit or a couple of movie tickets and dinner at a fancy restaurant.
5. The interest rate is reasonable. An interest rate with double digits would generally be considered unreasonable.
The best example of intelligent borrowing is a real estate loan, often referred to as 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, the borrower, find you can’t handle the payments or you want out for any other reason, you can sell the house and pay the lender from the proceeds of the sale. Because the loan becomes an asset for the lender, he can sell his position as well.
Is the debt collateralized? Yes. With a mortgage, the real estate is the collateral—the lender’s security. The lender has a legal lien on the property until the mortgage is paid in full, and that gives him a legal position in the transaction. If you as the borrower do not hold up your end of the bargain to which you agreed, the lender can take the property as payment for the outstanding loan.
Does the purchase have a reasonable life expectancy of more than three years? Yes, of course. This is true not only for the structure itself but also for the land on which it sits. Buying a home is a long-term investment.
Will the home increase in value over time? Yes. Real estate is always considered an appreciating asset, even though specific values may decline during economic cycles. As a general rule, real estate gains in value over time.
Is the interest rate relatively reasonable? Yes. In nearly all situations, mortgage rates are considerably lower than other types of consumer loans, usually by as much as two-thirds.
Toxic Debt
Take every aspect of the intelligent borrowing scenario above and think of the opposite. Now you understand toxic debt.
This is the kind of debt you agree to, often impulsively, when your desire is in high gear and your brain is in neutral. It is so easy to get into—much too easy.
A person with a credit card and an available credit limit can take out very expensive loans on a whim and at nearly every place, including the internet. You simply make your decision, swipe the magic plastic, sign your name, and presto! You’ve made a commitment to toxic debt. Painless? It is in the beginning. But not for long, my friend, not for long.
Let’s say you use your credit card to acquire the very latest notebook computer complete with LED-backlit retina display, a 2.8GHz quad-core processor, high performance graphics, 8 gigs of ram, a 500 GB hard drive and—the best part—a free printer. It’s on sale (which to many of us is a clear sign of providential entitlement), and you want it right now. You can think of so many ways this computer will simplify your life. You even justify that it will help you save money (not sure of the logic there, but I do understand the thinking). Why should your pathetic lack of cash prevent you from making this really good deal? (Remember the free printer.) You have just enough credit left on your account to cover it.
As you haul that baby to the car, the last thing on your mind is how you will pay for it. You didn’t consider for one second how this new debt will affect your current payment structure. It can’t be that bad, you reason, because you got approved. And you got a free printer!
Let’s see how this purchase measures up against the criteria for intelligent borrowing.
Does the borrower have a way out at any time? No. If you don’t pay as agreed, the credit card company won’t come after the computer—they’ll come after you. Unless you can sell the computer for what you paid for it (fat chance), you have no way out.
Is the debt collateralized? No. The credit card company is holding nothing of value to fulfill the debt if you are unable to pay. But they’ve got a tight grip on you. They don’t want that computer or anything else you buy with a credit card, for that matter. This loan is unsecured.
Does this purchase have a life expectancy of at least three years? No matter how you look at it, a three-year-old computer is not exactly cutting-edge technology. By its third birthday it has little monetary value, even though it may still compute. In fact, the features I listed above are already obsolete. Think about that for a minute.
Will the purchase appreciate in value? From the minute you walk out of the store, a computer is in the fast lane to obsolescence. It’s depreciating with every tap on the touchscreen or click of the mouse.
Is the interest rate reasonable? No. As of this writing, the average credit card annual interest rate is 16.82 percent,1 while a thirty-year fixed-rate mortgage is 3.72 percent per year.2
The computer purchase fails the intelligent borrowing test miserably by getting a no response to all five questions. Paying for a computer over time cannot qualify as intelligent borrowing. It is toxic debt.
Anatomy of a Toxic Debt
And it gets worse. Let’s say this computer deal we’re analyzing has a price tag of $3,200. The credit card terms are typical: 16.82 percent interest with minimum monthly payments of 4 percent of the outstanding balance. I just plugged those figures into my minimum payment credit card interest calculator at DebtProofLiving.com and—hold on to your wireless mouse—it will take eighteen years to pay the total price tag of $4,918, including the $1,718 in interest. Did you get that? Eighteen years to pay for a computer that will be functionally obsolete in three years or sooner. There’s no other way to characterize such a transaction than pretty stupid.
What will make things even worse is if, after two or three years, you decide to upgrade to a new computer even though you still have thirteen years to pay on the first one. Nevertheless, if the credit is available, it is quite easy to add another purchase (like a new computer) to the growing load of debt.
In no time at all, the forever revolving credit card balance is not seen for what it really is (a very high-priced loan on a lot of stuff you might not even own anymore) but rather as a normal part of life—like the rent, the phone bill, and the cost of food. In fact, I could show you high school personal finance curriculum that suggests keeping consumer debt at a manageable level, not to exceed 20 percent of income. I find that somewhat outrageous.
More than Toxic
While the computer example is remarkably illogical, other kinds of toxic debt make the computer scenario appear somewhat reasonable. Turning restaurant meals, groceries, utility bills, movie tickets, vacations, gifts, gasoline, and school clothes into debt and then choosing to pay for them with minimum monthly payments over many years and at rates that effectively double the original costs bring new meaning to the term toxic.
Spending money you don’t have yet to pay for things you don’t have anymore is anything but intelligent. Nevertheless, that is exactly what millions of people in this country do every day, every month, year after year after year.
Semi-Intelligent, Semi-Toxic
There are times when debt cannot be so easily delineated between intelligent and toxic. Sometimes it starts out intelligently and then turns toxic. The following are examples.
Home Equity Loans
As you know, a home mortgage qualifies as intelligent borrowing because it limits risk for both the borrower and the lender and is fully collateralized—at least it’s supposed to be that way. The homeowner can borrow only up to a certain limit, so the lender has reasonable assurance that the property’s current market value is more than the outstanding loan.
A home equity loan is typically a second mortgage that allows the homeowner access to the equity in the home (that margin between what is owed and what the property is worth). Equity is the borrower’s asset—and a precious asset at that. Home equity loans come in two flavors.
The first is a home equity loan (HEL)—a straight loan. When the paperwork is signed, the lender hands you a check for the full amount of the loan, minus costs and fees, if any.
The other type is a home equity line of credit (HELOC), which opens a large line of credit for you, for which you pledge your equity as the collateral. You can borrow against it whenever you want. In fact, the lender will be more than happy to give you access to your HELOC with a debit card that you can carry with you at all times to pay for anything. It’s like an ATM in your pocket.
Technically, both a HEL and a HELOC are secured debts because of the collateral feature. And the borrower’s safety valve remains because the home can be sold to satisfy the mortgage and the other loans against it. But it can be very risky—and that is what can push this type of debt into toxic territory. There are five ways the stupid factor can sneak into an otherwise intelligent mortgage situation:
1. If you borrow against your equity to clean up your credit card debt and then max out your credit cards all over again, you are left with twice the debt—that of the equity line and the credit cards. Not smart.
2. Some people treat a home equity loan as a permanent debt to be paid off when the house is sold. They would probably feel a greater urgency to pay off the debt if it was in the form of credit card balances.
3. The convenience of having your home’s equity available at your fingertips can be a formidable temptation. When money is readily available, you are more likely to fritter it away on something like a family vacation instead of saving it, as you might without the easy access.
4. If you are unable to keep current on both of your mortgages, either of the lenders can foreclose.
5. Sometimes the home equity loan and the first mortgage together exceed the market value of the property. But some lenders will still offer to finance not only the full value of the home but also more than the property is worth. You read that right. Even with all the lessons learned in the subprime debacle of the late 2000s, plenty of subprime loans are still available. These 125 percent loans put the borrower in a tenuous position—the monthly payments are severe, but selling the property ceases to be a way out because more is owed than it would bring at sale.
Even taking into consideration the fact that the interest on the home equity loan may be deducted from your taxable income, the risks involved with this potentially toxic debt can be weighty.
The equity in your home is an appreciating asset, for many people their only appreciating asset. If you leave it alone, it will grow as the property becomes more valuable and as you pay down the mortgage. That contributes to the intelligence factor of your home’s mortgage. To muddy those waters with a HEL opens the door to toxic debt.
Automobile Loans
A car loan can contain elements of intelligent borrowing provided you make a large down payment and select a model that retains a high resale value. An automobile loan is a secured debt; if you get into some kind of trouble, you can sell the car to repay the debt. Cars do not appreciate, however, so not all of the intelligent borrowing criteria apply.
A car loan can slide over to the toxic debt area if you put little or nothing down and stretch the payments past three years. It won’t take long for you to be “upside down” in the loan, meaning you owe more than the car is worth.
Student Loans
If ever there was a gray area in this matter of intelligent borrowing versus toxic debt, it has to be the troublesome student loan.
Some argue that a student loan qualifies as intelligent borrowing because the resultant education will appreciate over time and will more than pay for itself in future income. Nevertheless, that argument makes some bold assumptions: first, that you will actually finish school; second, that you will be well suited for the field in which you are getting your degree; and third, that the field will welcome you. I find it just short of amazing that 85 percent of college graduates do not end up working in their major field of study. (But then I recall the decisions I made at that tender age, and I understand fully. I majored in music.)
Whether student loans fall into the category of semi-intelligent or semi-stupid has a lot to do with one’s individual circumstances.
Recognizing the Difference
It is not difficult to recognize the difference between intelligent borrowing and toxic debt:
· Intelligent borrowing requires plenty of time to complete applications and receive approval. It makes you think. You can create toxic debt in your sleep.
· You are not likely to get in over your head with intelligent borrowing because you are qualified based on your debt-to-income ratio. Toxic debt can dump you into the deep end of the ocean before next Tuesday.
· Intelligent borrowing requires a lot of research and thinking. The last thing toxic debt wants is for you to analyze anything—just sign here!
As a person desiring to debt-proof your life, your mission is to rid your life and your future of all toxic debt, to borrow money only when it cannot be avoided, and then to do so as intelligently as possible.
The trouble with debt can be likened to the proverbial frog in the pot of boiling water. If you try to pop him in once the water is boiling, he’ll jump out. But if you start him out in cold water and slowly raise the temperature, he’ll just sit there and cook to death.
People are like that frog when it comes to toxic debt. We wouldn’t jump into the boiling water by purchasing something really big and expensive, like a car or a boat, with a credit card. But months and years of consistently making smaller purchases while paying only the minimum payment each month allows the temperature to rise ever so slowly. Before we know it, we’ve reached the boiling point.
Toxic debt doesn’t usually start out that way. In the beginning, it is simply a matter of convenience. You pay the entire balance during the grace period. Then one month the balance is a little too large, so you pay half and plan to pay the balance the next month. But then something comes up, and it appears to make sense to let the balance roll over to the next month. Soon you’ve got a balance too large to pay in full in a single month, and you’re on your way. The water started boiling, and you were completely unaware.
Why Is Toxic Debt Such a Problem?
Debt promotes discontentment. When you’re buying things with money you don’t have, you are not content with your income. You can’t be patient. You can’t wait. You have to have it right now! But when you acquire things too easily without pride of ownership, it is easy for you to become dissatisfied quickly.
Debt makes arrogant presumptions about the future. By agreeing to have things now and becoming legally obligated to pay for them later, you make bold presumptions about what the future will hold in terms of money, ability, and health.
What makes you believe that although you don’t have the money now you will have it later? But worse, you also promise that you will be willing to turn over money you don’t have yet to pay for things you may not have anymore. What makes you think you will be all that thrilled about spending money you’ve not yet earned for stuff you probably won’t even remember? That’s an arrogant attitude and an irresponsible presumption about the future.
Debt requires you to transfer your future wealth to your creditors. If given the choice between sending monthly checks to the wealthy credit card industry or sending those same checks to build your own future, would you really choose the former? When you agree to toxic debt, that is exactly what you’ve done. You’ve made your choice, and there is no way out but to make full repayment, no matter how difficult or unreasonable.
Debt limits your options—and heavy loads of debt eliminate them altogether. Debt keeps people tied to jobs and careers they hate. It forces moms who would rather be home with their kids to work outside the home. It can even give Mr. Right second thoughts about taking on a prospective bride because of her heavy, debt-ridden baggage.
Debt steals your freedom and makes you a slave. When you are under a load of debt, you are in bondage. You have no way out but to work off your sentence. King Solomon, said to be the wisest man ever to have lived, summed it up this way: “The rich rule over the poor, and the borrower is slave to the lender” (Prov. 22:7).
From here on out, I am going to omit the word toxic before the word debt. I’m sure I’ve made my point by now. Just understand that whenever you read debt in this book, it refers to toxic debt. Intelligent borrowing will be referred to as such and should not be construed to mean the same thing as debt.