Power Up Wealth podcast – Episode 112 – Good Debt, Bad Debt: Know the Difference
James Derrick 0:00
The world economy runs on debt from personal to corporate to government. We are awash in it, believe it or not, not all debt is bad. Stick to some rules and you’ll be okay. I’m James Derrick, President of Smedley Financial, and today we’ll be talking with expert and guest, Parker Thompson, about the do’s and don’ts of debt.
Shane Thomas 0:23
Welcome to the SFS Power Up Wealth podcast, where we provide impactful insight and expert opinions on timeless financial principles and timely investment topics, preparing you to make smarter decisions with your money.
James Derrick 0:38
Parker, thank you for joining me today.
Parker Thompson 0:40
Happy to be here.
James Derrick 0:41
Parker is a private wealth manager at Smedley Financial Services. He has a Certified Financial Planning designation, and he recently wrote about the do’s and don’ts of debt. Before we dive into the do’s and don’ts. Give us an overview of how you look at debt, personal debt, corporate debt, government debt. How should we be looking at it?
Parker Thompson 0:58
Yeah, we want to make the distinction between different kinds of debt. We hear a lot about it in the news, in terms of, you know, our government has a certain amount of debt, we’re 37 trillion in debt, or we’re adding this much trillion in debt each year. Numbers that don’t really compute in our own heads, right? And then we hear about corporate debt, and we hear about personal debt. We’re all familiar with our own personal debt. The distinction we want to make is the do’s and the do nots, at least for this show, or at least for this article that I wrote, was more for personal. There’s not a lot we can control in terms of how the government spends their money, and usually it’s a means to an end. The government is trying to use debt in terms of welfare or trade for going back and forth with countries, for defense, for servicing the debt that we’ve already accumulated. Corporate debt’s a little bit different, because it’s debt that companies use to either better their workforce or do research and development. Debt that usually is helping to power the company forward or help them to stay afloat. The debt that I speak of in this is what we can control on our home front, the personal debt decisions that we can make so that we can have a better financial life, so we can we can make better decisions.
James Derrick 2:00
Yeah, when you talk about corporate debt, staying afloat or powering growth, that’s two interesting distinctions. And so on the personal level, it’s kind of similar. Which debts are helping power your growth and which ones are just keeping you afloat? And I guess that comes down to like, what’s good and what’s bad debt. Maybe define that for us as well.
Parker Thompson 2:19
Yeah, you hear this a lot where you know there’s good debt and bad debt, and not all debt is bad, not all that is good. We can sort of look at the companies as a microcosm for our own lives, and say the companies are using debt in order to better operations, to become more profitable, to make their financial situation better. If we are going to use debt and use it sparingly, we should be doing the same thing. We should be using it to better our financial lives. We should be using debt to invest in things that go up in value, that don’t put us at risk. So typically, what you see is the good debt being assets that grow or that accumulate or that appreciate in value. A home, for instance, is an example of that. A business that hopefully one day will turn a profit or provide a lot of income. Assets like these are typically what we think of in terms of good debt, or student loans for an education that could eventually earn you more of an income, a higher salary. I’ll put a caveat on that. One is in terms of student loans, because there are degrees out there that don’t make a whole lot, that people spend a lot of money on and go into debt for. So you want to make sure that you’re getting, you know what, what’s worth it in terms of value of that education. On the flip side of things, we see bad debt. These are the ones that are typically on cars or consumer products, furniture, entertainment, travel, things like that. None of these things are inherently bad, right? We all need cars to get around, to travel. We all need, you know, a vacation every once in a while. But if we’re doing that on debt, and it’s a depreciating asset or a depreciating value, that is typically what we call bad debt.
James Derrick 3:47
That’s a great introduction. Let’s dive into then the do’s of debt.
Parker Thompson 3:52
The first do of what to do with debt is to create a plan for paying back debt. There’s two methods here. There’s the Avalanche method, and then there is the Snowball method. And we can kind of dive in more, but there’s two ways, either paying the high interest rate first, or paying the lowest payment first and then letting that snowball into the next one. But do pay back debt with a plan. If you don’t have a plan, and we’re just kind of making the minimum payments here and there on all of our debts, we’re not really going to get anywhere. There’s not going to be any traction. The second one that you mentioned is borrowing good debt, right? We want to be cognizant of what good debt and bad debt is, and if we do need to borrow it, make sure it’s good and the last do is to pay off high interest credit card debt. Credit card debt can be some of the worst, getting up into 20 or 30% in terms of interest rates. So we want to make sure we pay those off as soon as possible.
James Derrick 4:41
You talked about Avalanche and Snowball. The general rule of thumb would be that you pay off whichever credit card has the highest interest rate. So for listeners out there who are trying to decide how to tackle the debt challenges that they have, that’s a good place to start. But if the lower interest rate and you correct me if I’ve got this wrong, but the lower interest rate could be paid off first, if it’s going to help you take care of that monthly payment, and then you can apply that monthly payment to another credit card. And this is called snowballing?
Parker Thompson 5:14
Yeah, you’re rolling the next debt into it. So there’s two different schools of thought here. I’ll tell you that what works best for each. Mathematically, the Avalanche Method is the best in order to get the debt paid off the quickest and to not hurt your financial situation the most, because you’re taking the highest interest debt first, you’re not being charged or it’s not going negatively against your net worth, and you get to pay off that faster, right? Mathematically is what it makes sense. There’s a whole flip side of the coin here, where the Snowball method is more of behavioral. And we want to pay attention to this, because you want to do what works best for you. Some people like to take the smallest payment possible, the smallest debt possible in terms of amount, pay that off, and then whatever you were putting towards that debt, you roll it into the next one, roll it into the next one, so on so forth.
James Derrick 5:57
And all those minimum payments are going towards one large payment, right? The final bill.
Parker Thompson 6:02
Yeah, the final bill. And what we see is typically, people will see more victories, or they’ll see more wins initially. And as you pay off one debt, pay off the next one, you get that sense of, I completed it. I completed the task. So behaviorally, we see that a lot of people have more success that way. Mathematically, like I said, it makes more sense to pay off the high-interest ones, because those are hurting you sooner.
James Derrick 6:26
Let’s talk about the don’ts.
Parker Thompson 6:28
The don’ts of debt. Don’t borrow outside of your limits, right? There are certain limitations of how much we historically want to borrow for things like a home or all debt combined. We don’t want to borrow outside of our limits in terms of our earning power. We don’t want to become house poor. We don’t want to become car poor. We want to make sure we’re within those limits. The other one is, do not borrow bad debt. We’ve we’ve gone over that a couple times, but know what it is. Try to stay away from buy now, pay later. Try not to take out loans on furniture or consumer shopping, those, those types of things. And the last one is, try not to pull from retirement accounts in order to pay debt. There is a very small case scenario where that might make sense, but we do not want to pull from retirement accounts to pay back our debt.
James Derrick 7:12
Let’s go back to the limit. What kind of limit are we talking about? Who sets the limit?
Parker Thompson 7:17
This is, historically, just a fundamental that financial advisors have set as a precedent to say, if you can borrow within these limits, you will have enough left over to pay for lifestyle, to be able to live comfortably, to afford everything else in life. The limit set forth for housing, for example, is 28% we don’t want it to exceed 28% of our gross monthly income. If we go much above that, we start eating into our purchasing power for groceries, our purchasing power for insurance and medical bills and all these other things that that we predict or assume, the total amount that we want to be borrowing for debt should not exceed 36% as a whole of all of our monthly earned income, monthly gross income, again, these are more just set in place to keep us in check, so that we have the emergency fund in place, so that we’re able to invest proper amount for retirement. If we go above these limits, it really pinches us, and we’re not able to save as we would like, or live the lifestyle that we would like.
James Derrick 8:13
Now I imagine that these limits also are going to be very different what you’re sharing versus what I might find online, or what the credit card company might be offering, or the mortgage broker that I’m working with, those amounts are probably going to be a lot higher than I should ever use.
Parker Thompson 8:29
Absolutely. The bank is going to give you up to 50 or even 60% in some cases, to your gross income, which is insane and should never even be considered, right? They’re usually in the range of 40 to 50%, but even that is a little too much to handle for most people given to current situations. The car salesman and the financing officer in the back of the car sales lot is going to give you whatever payment for however long, for whatever amount that you like, whatever fits within your monthly budget. But again, it’s not always the right decision. They don’t necessarily have those other thoughts in mind in terms of what else you need to be paying for in life.
James Derrick 9:01
You have seen that even on auto loan now you can do 10 year loans. The problem is, is you might end up underwater, owing more than the car is worth.
Parker Thompson 9:09
And it may fit within this limit of you know, we want to have 36% of our gross income just based on the payment, but soon enough, if you own a car for 10 years, I think we all know that you start to have to pay for the repairs eventually, right? And more and more. And so all of a sudden those costs are not taken into account, and all of a sudden your payment is such that you can’t handle the extra repair costs. Again, these are all fundamental amounts that we put on just to make sure that we’re keeping ourselves in check.
James Derrick 9:33
Let’s jump to the using retirement accounts. Why is it a bad idea to pay off debts with your retirement savings?
Parker Thompson 9:39
One thing that a lot of people don’t understand is the compounding power, or the potential power of your retirement accounts. If you will, just continue to add to them and let them build and build and build. We talk a lot about on this podcast, is the compounding interest and the power of time and just leaving your investments in the market for a long time. If you have a large debt that. You want to take out of your retirement to pay for, if you like, if you want to take out retirement to buy, you know, a car or a house even, you’re trading essentially something for today, for satisfying today’s interest for a long-term sacrifice. You’re sacrificing your retirement long-term, right? We don’t want to mortgage our retirement to get something today. There are case scenarios where this makes sense, where your interest rate is so high that it’s actually more detrimental to your net worth. In the case of credit card debt, if you have a large amount of credit cards that have a high-interest debt, it’s eating away at 20 or 30% per year. It’d be far-fetched for the market to do 20 or 30% each year in order to combat that. So if you are really in a dire situation, it might make sense, but for just normal, regular payments, we want to let that retirement sit and build and compound for as long as possible. If we take it out for any sort of a payment on something that we would just have to take debt for, we could be really sacrificing our future.
James Derrick 10:55
Thank you for coming in, Parker. Appreciate it.
Parker Thompson 10:57
Thanks for having me.
Shane Thomas 11:00
Thank you for joining the Power Up Wealth podcast. Smedley Financial is located at 102 S 200 E Ste 100 in Salt Lake City, UT 84111. Call us today at 800-748-4788. You can also find us on the web at Smedleyfinancial.com, Facebook, Instagram, Twitter, and LinkedIn. The views expressed are Smedley Financials and should not be construed directly or indirectly as an offer to buy or sell any securities or services mentioned herein. Investing is subject to risks, including loss of principal invested. Past performance is not a guarantee of future results. No strategy can assure a profit nor protect against loss. Please note that individual situations can vary. Therefore, the information should only be relied upon when coordinated with individual professional advice. Securities offered through Osaic Wealth, Inc., member FINRA/SIPC. Investment advisory services offered through Smedley Financial Services, Inc.® Osaic Wealth is separately owned, and other entities and/or marketing names, products, or services referenced here are independent of Osaic Wealth.
The Do’s and Do Not’s of Debt — Parker Thompson
