Debt 101: What It Is, and Why You Must Care

Debt is a topic you can hear people discussing just about anywhere, from the barracks to the "head shed," from your buddies to influencers to financial "gurus." It's fair to say, in fact, that America is a nation of debt, and has been since the union assumed state debt under the Compromise of 1790. If you've watched or read Hamilton (yes, it's based on a book by Ron Chernow!), you know this was a huge disagreement among America's Founding Fathers! The debate that raged then rages on today.

When the U.S. government assumed state debt, it was able to sell bonds to rich investors. This helped the government raise enough cash to fund the army, build a navy, construct railroads, roads, and bridges, and invest in industry and infrastructure. In the long run, that $25 million has helped the U.S. grow into the world's richest and most powerful nation. In other words: it was a brilliant investment (thank you, Alexander Hamilton!). But it isn't always brilliant, and new debt from the centuries since to pay for dead-end programs, disastrous wars, and dozens of other failed projects were equally terrible.

Today it isn't so much a topic of national importance as it was between Hamilton and Jefferson, but in the sphere of personal finance debt remains a highly polarized topic. Some, like Dave Ramsey, have build a brand on helping Americans be debt-free; others, like Robert Kiyosaki, have started companies to educate Americans on how to use debt to become rich. And in personal finance just like with national debt, in some cases it can be brilliant and in others terrible. The real answer about whether debt is good or bad, whether you should or shouldn't use it, is "it depends."

So before you get too comfortable with debt and assume it's "no big deal because everyone is doing it," or before you go all-in with one side of the debate or the other, take a moment to understand it.

The Good, The Bad, and The Ugly

Debt, in itself, isn’t inherently bad. That means making moral judgements just doesn't make sense and debating it on that level is a waste of time. Debt is just debt -- yet some of it still gets labeled as "good" while some gets categorized as "bad." The distinction between good and bad debt doesn't have anything to do with how you got it: a $20,000 loan for 60 months at 7.2% can be good or bad. What matters is how you use the debt.

Good Debt: Investing in Your Future

Good debt is debt that will leave you better off in the long run -- in other words, you'll end up with more money because of the debt. Good debt buys assets that generate income, increase in value, or do both. So long as you remember this, it will be easy to make decisions about whether to use new debt to purchase things: "will this result in more wealth or less?" Examples include:

1. Education Loans: Student loans get a bad rap, but in reality financing your education can significantly increases your earning potential and job opportunities. The problem arises when the cost is huge (say $400,000 for private school that could take 20-40 years to pay back in the form of higher wages), or when there is no payoff (getting a masters degree in the military will not get you promoted faster, lead to a higher Base Pay, or provide any Incentive Pay bonuses).
2. Real Estate Investments: Real estate is a double-dip: it produces rental income now, and higher value in the future. In U.S. markets, real estate has averaged 3.5% growth per year on top of an average annual increase in rent of 3.5 to 5%. When purchased with a home mortgage, the returns are even better because you will also get the rent and profit on the money the bank lent you. This often results in Returns on Investment (ROIs) of 15-20% per year or more!
3. Business Loans: While 7 in 10 American millionaires made their riches in real estate, 10 out of 10 American millionaires have at least one business they run. And on average, the wealthy have seven different forms of income, including multiple businesses. Taking a loan to start or expand a business that will generate profit is an excellent example of good debt, and is one of the clearest paths to Financial Freedom.

Bad Debt: Paying for the 'Right Now'

Bad debt, on the other hand, is debt used for consumerism or the purchase of depreciating goods. In other words, you end up with less money because of it. An example is buying a $20,000 car with an auto loan of $20,000 paid back over five years. After five years, you will have paid $26,000 or more for the loan including interest, and the car will be worth only about $10,000. Once again, this makes a decision about taking on debt easy because you just ask yourself: "is it a good idea to spend $26,000 for a $10,000 car?" (If you need a hint, the answer is NO!)

A major problem in America is that this is how banks get rich, and so it's generally incredibly easy and popular to take on these kinds of debt. But as with most things that are popular and easy, the reality is they're actually really bad for you -- and the same is true with easy financing. Examples include:

1. Credit Card Debt: High-interest debt incurred from everyday purchases.
2. Auto Loans: Financing a car, especially a new one, which depreciates rapidly, often leaves you with more debt than the asset’s worth. (This is what's called "upside down" in finance terms.)

Ugly Debts

Sometimes you just need to take on debt to get through life. It may be your only option when you're just getting started working, so you may have an auto loan or even carry a small amount of credit card debt from getting your first apartment, buying clothes, etc. Don't feel bad about this -- just make it a mission to pay it off as soon as possible, because it is bad debt. But bad becomes ugly if you have taken on that debt not for essentials like food, housing, clothing, but for non-essential things:

1. Credit Cards for Non-Essentials: Carrying credit card debt because you wanted to glow up your ride, take a vacation you hadn't saved for, or eat delivery meals every night is one of the worst financial decisions (or habits) you can have. You need to stop this immediately.
2. Personal and Payday Loans: About the only time you can justify these is if you need the money to post bond and get out of jail. Otherwise, whatever you want to buy just needs to wait.

Effective Debt Management

The best plan when it comes to bad debt is to simply avoid it. That means that you need to manage your expenses and cash flow so that you can save cash for major purchases. The idea of saving $8,000 to buy a car can sound intimidating: save $750 a month for 12 months, no way! Many don't want to save that much, so they just go finance a car. But the truth is that the average car payment in 2023 in the U.S. was almost as much: $620 per month. If you have a loan payment like that of course saving $750 sounds too hard -- but the difference in cash flow if you didn't have the loan is only an extra $130 per month. Everyone in the military can afford that.

Better still, if you keep saving that much each month during years 2-5, at the end of five years you'll have $32,000 in the bank. You'll also have a well-used car now worth only about $4,000, but you are in a position for a really nice upgrade to your car, debt-free. Compare the choice of avoiding debt to the choice of financing your first car as described earlier in this post:

• Finance: paid bank $26,000, have a $10,000 car and $0 savings. Net position = minus $16,000
• Cash/Debt Avoidance: paid $8,000, have a $4,000 car and $32,000 savings. Net = $28,000

In your five years in uniform, this single choice about the car will be a difference of a positive $44,000 to your bottom line. Now multiply the choice to use bad debt over a 20-year career -- or even over a lifetime -- and you'll be looking at a difference in the hundreds of thousands of dollars.

In addition to saving cash to buy the car and avoid debt, you also need an adequate Emergency Savings Fund to avoid taking on bad debt in unpredictable circumstances. For more on this topic, read our previous post here, and listen to our Podcast here.

Debt Payoff Strategies

If you have debt, and be honest most of us do, your mission becomes to eliminate this debt as quickly as possible. Again, we're not talking about a mortgage (worry about making that go away once you're on "final approach" to retirement), but auto loans, credit cards, etc.

Paying off debt is easier said than done, however, because lenders structure loans to get more interest up front, and apply less money to the principal (the amount you borrowed), which is what you must pay back in order to cancel the debt. That means that payment plans are designed to make them rich, and make it harder for you to pay off debt. For that reason, so long as you can avoid it, you must never make minimum payments and always pay the balance owed by its due date.

But what if you've been carrying a balance? To get long-standing balances to zero requires a strategic approach to quickly knock down targets and get out of debt. There are three generally accepted strategies for doing this:

• Debt Snowball. Pay the minimum balance on most debts, and make maximum affordable payments on the debt with the smallest balance. Once that debt is paid, take all of the money for that payment and apply it to the next smallest balance. Continue until all debts are paid.
  • Advantages: quick wins, builds confidence
  • Drawbacks: more interest accrues, more expensive in the long run
• Debt Avalanche. Similar to the Snowball, except the order is determined by the interest rate on the debt: start with the highest interest rate and end with any debts that are 0-2%.
  • Advantages: most efficient, cheapest, usually fastest
  • Drawbacks: can take time to conquer the first debt, which is potentially frustrating
• Debt Flood. Equally apply additional payments to all debts to steadily lower all balances at a relatively equal rate.
  • Advantages: easy to manage
  • Drawbacks: inefficient, still pays high levels of interest, usually slowest overall

The Debt Flood is not a great strategy -- but it can work, so you should consider it. Generally the debate is between the Snowball and the Avalanche. At the Military Wealth Coach, the Avalanche method is our preferred strategy because it minimizes total interest payments, which will save you money and help you start investing those savings sooner to start building wealth faster. 

Here is a comparison of the Snowball and Avalanche methods for someone with three debts: 

 • Credit Cards: $50,000 at 18% interest

 • Auto Loan: $30,000 at 6% interest

 • Student Loan: $10,000 at 12% interest

• Snowball order: Student Loan --> Auto Loan --> Credit Cards
  • Total principal + interest: $168,858.64, time to "debt-free": 106 months 
• Avalanche order: Credit Cards --> Student Loan --> Auto Loan
  
  • Total principal + interest: $157,166.31, time to "debt-free": 99 months

As you can see, when interest rate is used to determine order, you could save over $11,000 in interest payments over 8 years and pay off your debts 7 months faster. This is achieved at the same monthly payment on the debts, so your cash flow is the same either way. When you can save money and move faster for the same cost, you have found a better way to pay!

America's Debt Nightmare: How Debt Will Hurt You

For many service members, homeownership is a significant milestone; homeownership is a major part of the American Dream. On top of that, over 16 million self-made millionaires in America built their fortunes on real estate. Importantly, the military lifestyle combined with military benefits offers one of the best and quickest paths to achieve Financial Freedom through real estate investing.

However, carrying too much debt can severely impact your ability to secure a home loan, and could turn your dream of homeownership into a total nightmare. Lenders use the debt-to-income (DTI) ratio to determine your ability to manage monthly payments and repay borrowed money. A high DTI ratio indicates that you have too much debt relative to your income, which can make it challenging to get approved for a mortgage.

For most lenders, a DTI ratio below 36% is ideal, and by law they are not able to offer you a loan if your DTI reaches 43%. This law was enacted in 2010 after the Great Recession, and was intended to protect the economy from bad loans, and Americans from predatory lenders. Since it's law, there's no way to get around it, so you must consider this from the very beginning of your financial journey.

Most service members opt for a VA loan because of its benefits that make it so accessible, such as no down payment and competitive interest rates. However, this can make carrying debt in the form of auto loans and credit cards more than just risky -- they can become show-stoppers. Because VA loans allow for a 0% down payment, the mortgage and monthly payments can be higher compared to conventional loans with a down payment. You may find you don't even qualify.

For example, if I want to buy a $400,000 home with a conventional loan and 20% down, the bank will finance $320,000. Now you with your VA loan want to buy that same house and go to the lender for a VA loan with 0% down, meaning the bank has to finance $400,000. That mortgage payment will be 25% higher than the mortgage payment on the $320,000 loan, and if you've got credit cards and auto loans, it will likely push you past the 43% DTI cutoff. The lender may come back and only approve you for $320,000 in order to keep your DTI at 43%. Now you have to decide if you want to buy a $320,000 house and let me have the $400,000 one -- or come up with $80,000 cash on the spot.

To ensure you qualify for a VA loan and can afford the home you want for your family, it’s crucial to minimize your existing debt. And in the long run, to continue qualifying for mortgages to build your real estate empire, you will need to carefully manage your Debt-to-Income ratio. Instead of using the cash flow from your early investments to quickly add more real estate (or to spend it quickly on lifestyle choices), use your growing wealth to further reduce your debt and clean up your financial house.

Conclusion

Debt is neither good or bad, but it becomes one or the other depending on how you use it. When used wisely, it can be a tool for building wealth. However, mismanaged debt can derail your financial goals, particularly homeownership, and leave you in a lifelong struggle of trying to pay off the debts. This can leave you in the awful situation of living Paycheck-to-Paycheck, unable to save for your future. By the time you're debt-free it may be too late to achieve any of your financial goals and dreams.

Remember the difference between "good debt" and "bad debt" is what you do with it: don't borrow to buy cars and stuff, but by all means take out loans to buy assets, invest in real estate, start businesses, and invest in yourself and your family with better education credentials, professional skills and licenses, etc. When you increase your value and your investments, you will end up with far more income and wealth using debt than you could ever achieve trying to do it without.

In order to make sure you can get debt when you need it to build your wealth and achieve Financial Freedom, avoid bad debt at all costs. Make sure you have enough cash savings to buy what you want when you want it, and adequate Emergency Savings to avoid debt in unexpected situations. If you have debt, get rid of it as fast as you can by using a strategy appropriate to your situation. You can compare which strategy is best using our Debt Dashboard comparison tool that is part of our Ultimate Budget Planner, available for Instant Download from The MWC Store on Etsy.