Most of us have a basic understanding of how credit and debt works based on our personal experiences. We borrow someone else’s money (the bank’s, the mortgage company’s, a friend’s), then we buy something and repay the lender with interest. That’s the basic formula: whether credit is for a house purchase, a car, or dinner at a restaurant.
Likewise, the typical questions asked are as simple as, “Who will lend me the money, and can I afford the payments?” While important considerations, we also think there are equally important questions that people aren’t asking. And right now, the question on many people’s minds is, “What will happen to debt if the dollar inflates?
So let’s talk about debt–good debt, bad debt, inflation, and credit. How do these ideas fit together?
Credit is Like Lighter Fluid
After all, credit gets things started—having a credit score allows you to participate in things like home and car buying, as well as investing. Unless you plan on paying for everything in cash (we don’t recommend it), having a credit score (and an excellent one) is necessary.
While having a credit score means taking on some debt, it shows creditors and lending institutions that you can make payments responsibly (or not). While racking up credit card debt can leave you in a tough position, using your card and paying off the balance can help you build a healthy credit score.
Without credit, banks are often unable to loan you money because they have no record of your ability to repay loans. So whether you’re planning on purchasing a house, or looking to start a business or invest in real estate, it’s important that you build healthy credit.
Credit and Opportunity Cost
In simple terms, opportunity cost is the potential future growth you lose by spending your dollars in one place over another. If you pay $30,000 in cash for a car, you have your car, yet you lose the potential growth the $30,000 could have earned if saved or invested at a high interest rate.
Debt allows you to partake in opportunities WITHOUT depleting your savings accounts. Then, if you choose, you can use the remaining cash for OTHER opportunities. Say that $30,000 goes towards a cash flowing investment, and the cash flow allows you to make your payments. Once you’ve paid off your car, you’ll still have the income from your investment.
It’s important that we stop looking at debt as a mere “necessary evil,” and instead start asking—“Can this debt further my desires, or help me partake in more opportunities?”
While the answer won’t always be yes, it’s important that we recognize the difference between “good” (helpful) debt and “bad” debt.
Debt: The Good and the Bad
Too often, all debt is lumped together as bad. People see the word interest as a four letter word and do everything they can to avoid paying extra. Yet we forget that many things simply aren’t practical without some sort of access to credit.
Home ownership, for example, can be difficult if you aspire to pay cash. It may take you years of saving, all while paying high rent prices. Yet if you could leverage debt to own a home sooner, there’s a possibility that your mortgage payments could be lower than rent, perhaps by hundreds of dollars. How much more would you be able to save each month, if that were the case?
We define good debt as debt that is backed by an asset—like owning a home, a car, or a rental property. Debt that helps you to secure an asset can produce cash flow, allow you to drive to work, and put a roof over your head.
“Bad” debt, on the other hand, is a debt that racks up quickly with no assets behind it. The biggest culprit can be credit card debt—one time purchases often don’t do anything for us beyond a rush of endorphins. Then, you’re stuck paying off that item long after you’ve gotten your initial enjoyment. This kind of debt can quickly lead to poor spending habits, and can get us in trouble–yet most people have been through it at some point.
However, we still want to avoid labeling any debt as purely “bad.” While credit card debt can lead to unwise habits, credit cards are also a credit-building tool. Knowing when to leverage your credit, and when to pull from savings, can be useful.
The Impact of Inflation of Debt
Since COVID-19 began, there have been whispers of going into a period of higher-than-usual inflation. While this may sound like reason to be cautious, inflation actually improves good debt.
If inflation decreases the impact of your dollar, the same must be true across the board, right? This means that inflation positively affects things like mortgages and car loans, because the VALUE of your debt decreases.
This is the same reason we’re seeing banks push homeowners into refinancing into 15-year mortgages. Inflation negatively impacts the banks, because the value of your payments aren’t going as far as they used to. Shorter mortgages (AKA, higher payments) cut back on that inflation significantly, and give the banks more control.
While this may not be the best time to take on any new debt, depending on your personal circumstances, this is a great time to hang onto the payments you’re already making –especially secured, low-interest debt such as a car loan. Instead of paying it off, save and invest where you have greater *control of those dollars. More than ever, consider how you can inflation-proof your savings. And the best way to do that is to use extra dollars to save and invest rather than focusing on paying down “good” debt. (Hint: inflation also makes your life insurance premiums feel lower over time, while earning a rate that often outpaces inflation).
Want to Leverage Debt Like the Wealthy?
We specialize in alternative strategies for life insurance and investments. If we can answer questions or assist you with implementing any of these strategies, don’t hesitate to contact us.
by Carol Dewey