Here’s a confession, I do like to watch Dave Ramsey on Youtube, his take no prisoners approach is quite entertaining. Yet, he often is condescending, which seems unnecessary at times. After-all, people are calling him for his support and reaching out is always a good positive step.
Dave Ramsey is also often considered as a strong proponent of debt bad movement. This is not bad advice at all, yet, is debt really bad for your goal of financial independence? However, instead of simply listening to the gospel, can we really assess this?
The purpose of taking loans
The first step is to understand, why is there a need to take debt? It is simply to finance a good or service which you otherwise cannot afford through your regular income and savings. You are borrowing against the promise of your future income.
Digging into my debt collection experience in finance industry
Around a decade ago, I was working in the finance industry in India. I had a few takeaways:
- We had customers owning Ferraris on loan, with ridiculus payments, which they failed to pay off. In the eyes of their social circle, they were considered very rich.
- Many customers financed their commercial vehicles to earn money by transporting goods, without learning the costs of the business.
Both of the above examples are the real issue here.
#1 : Debt is bad when you take too much of it
While banks might only look at your credit score or income statements, they cannot predict if you will be able to sustain your debt. Can your choice to buy a ferrari cripple rest of your finances?
If your debt repayment will make it impossible to save anymore each month, then you are buying more than you should. Pare down on your wants, and evaluate if you can opt for a more cost effective solution.
Great loan offers give us an illusion that our spending capacity is more than what it actually is. This often means, we are willing to consider buying things which we should ideally be out of our consideration.
#2 : Don’t call debt bad when your math is bad
The whole idea of debt as a financial product is to earn money through interest rates. This is the return the banks will get after you are done repaying your loans. Thus a simple comparison between two debt offers is comparing their interest rates (and reading the small print).
Comparison of interest rates may not be the whole picture, you should consider the total cost of ownership as well.
For example; if you are buying a car, you will end up having monthly car payments, fuel, parking, maintenance, winter tyres and insurance costs. Add it all up, and split into monthly payments. This number should be affordable, else you need a cheaper car or delay the purchase.
The same applies to buying houses, or rental properties and even buying a TV on loan (monthly payments + electricity + cable costs).
What is the downside of too much debt?
Lets stick to the math of taking debt, and avoid a discussion on mental stress. Let me share a real life example of a friend, he bought an apartment in India with a 25 year mortgage. His monthly payments translate to around 1000 EURs (converting from Indian rupees) at an interest rate of 10%.
As a single income household, he finds it really hard to save after his monthly expenses. His only means of saving are the mandatory rentenversicherung payments. His mistake was borrowing against future earnings of two adults instead of one.
In hindsight, a smaller cheaper apartment would have made sense.
What is an acceptable debt?
Acceptable debt is a combination of sufficient equity (downpayment), manageable interest rate and viable payments.
In the current context of Germany, I would rank the below debts and my preference:
|Type of Debt||GetFI Rating||Why|
|Personal Credit||Avoid||Avoid due to high interest rates, unless you use it to pay off a loan of even higher rate.|
|Mortgage (Baufinanzierung)||Ok||Historically low interest rates (<2.5%), try to start with atleast 20% downpayment (more the better)|
|Credit Card||Avoid||Unless you can stick to paying off the whole credit each month, just avoid. |
Currently interest rates range 13%-19% per year!
|Payday loans (minikredit)||Run||If you need to consider this, you are in trouble|
|Auto Loans||Ok||I suggest a high downpayment, dont buy a car you cannot afford. |
Make sure interest rates<4% and contract upto 48 months.
The debt principles
Lets summarize our tips for acceptable debt (I won’t call it good debt):
- When financing a property, use a broker like https://www.loanlink.de/ to get best rates from banks specially when you are not comfortable with German. (I have not used their services, they are an example)
- When buying a property, go 20% or higher in downpayment, else reconsider your decision.
- Avoid new cars for loss of value, buy in cash.
- If you still need a car loan then limit runtime to 4 years and interest<4%. Try not to finance more than 50% of the value of the car.
- Do your math, for apartments add costs of commission, registration, maintenance. For cars, running costs, parking and maintenance. These will give you an idea of your monthly expenses.
- Always check loan prepayments options before signing on. The goal should be to have the opportunity to prepay loans without a penalty fees.
- In case of prepaying debts, hit the one with highest interest rate first.
In short, be responsible with your choices, do not take undue risk. Too much risk can make you poor.