Semi-Intelligent or Semi-Stupid Debt
You've learned the basics of intelligent borrowing, but that is only half the road to debt-proofing your life.
There are times when debt cannot be so easily delineated between intelligent and stupid. Sometimes it starts out intelligently and then turns stupid.
As you know, a home mortgage qualifies as intelligent borrowing because it limits risk for both the borrower and 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 has a current market value more than the outstanding loan.
Home Equity Loans
A home equity loan, curiously known in the industry as HEL, is typically a second mortgage that positions itself in such a way to allow the homeowner access to the equity (that margin between what is owed and what the property is worth). Equity is the borrower's asset—and a precious asset at that.
A HEL opens a large line of credit for you, pledging your equity as the collateral. You can borrow against it whenever you want. Technically it is a secured debt because of the collateral feature. And the borrower's safety valve remains because the home can be sold to satisfy both of the debts. But it can be very risky—and that is when it can cross over into stupid territory. There are five ways the stupid factor can sneak into an otherwise intelligent mortgage situation:
- If you borrow against your equity to clean up your credit card debt and then run up your credit cards all over again, that leaves you with twice the debt—the equity line and the credit cards. Not smart.
- Some people treat a home equity loan as a permanent debt to be paid off when the house is sold. They might have felt a greater urgency to pay off the debts if they were in the form of credit card balances.
- The convenience of having your home's equity available at your fingertips can be a formidable temptation. Knowing the money is readily available, you are more likely to fritter it away on something, like a well-deserved family vacation, instead of saving the money first as you might have if you did not have such easy access to your precious equity.
- If you are unable to keep current on both of your mortgages, either of the lenders can foreclose.
- Sometimes the home equity loan and first mortgage together actually exceed the current market value of the property. There are lenders these days who offer to finance not only the full value of the home, but more than the property is worth. 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 deductible from your taxable income, the risks involved with this potentially stupid 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 stupid debt.
A car loan can contain elements of intelligent borrowing provided you make a large down payment and select a model that historically retains 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 stupid 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. Borrowing a car for a long period of time, also known as leasing, is in most situations anything but intelligent. Getting caught on the leasing treadmill can be a very expensive proposition.
If ever there was a gray area in this matter of intelligent borrowing versus stupid 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 is making 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.)
Whether student loans fall into the category of semi-intelligent or semi-stupid has a lot to do with one's individual circumstances.
Recognize the Sign of Debt
It is not difficult to recognize the difference between intelligent borrowing and stupid debt:
- Intelligent borrowing requires plenty of time and makes you think. You can do stupid debt in your sleep.
- You are not likely to get in over your head with intelligent borrowing. Stupid 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 stupid 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 stupid 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 stupid debt. We wouldn't jump into the boiling water by purchasing something really big and expensive, like a car or boat, with a credit card, but months and years of consistent spending for 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.
Stupid debt doesn't usually start out stupid. 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 larger than can be easily paid, so you pay half and plan to pay the balance next month. But then something comes up and it appears to make sense to lot it roll over into the next month. Soon you're hooked with 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.
So why is debt such a problem?
- Debt promotes discontentment. When you're charging things with money you don't have, you are not content with your income. You cannot be patient. You cannot wait. You have to have it right now! But when you acquire things too easily without pride of ownership, it is easy 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 on the future.
- Debt requires you to transfer your future wealth to your creditors. If given the choice of sending monthly support checks to the wealthy credit card industry or sending those same checks to build your own future, would you really choose the former? Probably not. However, when you agree to stupid debt, that is exactly what you've done. Your choice has been made, and there is no way out but to make full repayment, no matter how difficult or unreasonable that will be.
- 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 stupid debt, you are in bondage. You have no way out but to work off your sentence. King Solomon, the wisest man ever to have lived, summed it up this way: "The rich rule over the poor, and the borrower is the servant to the lender" (Prov. 22:7).
From Debt-Proof Living: The Complete Guide to Living Financially Free, published by Broadman & Holman Publishers. Copyright © 1999, Mary Hunt. All rights reserved. International copyright secured. Used by permission.