Classifying your debt: The Good, the Bad and the Ugly
Back in June, I asked “what’s our next early payoff challenge“. We have credit card, auto and student loan debt, plus our mortgage (but that doesn’t count right now). I was really leaning towards paying off our credit card debt next, even though it’s at 0% interest, whereas our student loans and auto loan are at least 4.5%. Guess which debt we took on next. Yep, the credit card debt.
You may call me stupid, foolish, or dumb for not paying off our highest interest rate first, but it’s not always about money. Let’s take a closer look at our debt, and think about it in a new way:
The Good
If there’s a general consensus on a good debt, it has to be student loan debt. Personally, I think all debt hurts, but student loan debt probably garners you the most benefits of any of your debt, including a mortgage. As of writing, we have a little under $27,000 in student loan debt:
- Mike: $14,705 at 6.25%
- Stacie: $11,734 at 5.75%
We both started at about the same debt level (even though Stacie has her Masters and I’m just starting on mine), but we paid a few grand more on Stacie’s when trying to get rid of some loans when we consolidated.
The Bad
I consider my “bad loan” to be my car debt. At one point, we had $53,000 in auto loans, but now we’re down to less than half that total now. Also we just sold a car this past weekend for $10,500, but we have other plans for that money.
- Mike: $22,330 at 4.50%
The Ugly
The only debt left has to be the ugly one: credit card debt. Why is it ugly? Because I can’t think of much that I have left to show for that debt. It’s been following me around for years (yeah, so has the student loan debt), but I’ve finally taken action against it. We’ve gone from $20,000 in credit card debt down to under $6,000 in about 17 months.
- Mike & Stacie: $5,687 at 0% (until November)
Comparing Debts
So, back to our debt payoff schedule. Why would we pay off the 0% interest debt before the student loan debt (the highest interest)? Not all debt is equal:
I mentioned in “Is the thought of debt ruling your life?” that we have plans to be debt free in order to have the freedom for one of us to stay at home with our future child, or to be able to move closer to our families. This means that we think about our debt in 2 dimensions:
- The monthly cost of our debt. That is, how much of our monthly payment goes towards interest. Ultimately, this all adds up, which is why debt is bad. You’re paying way more for your stuff than it’s worth.
- The risk of each debt.
Let’s talk about risk a bit more…
The Risk of Your Debt
What do I mean by debt risk? Think of it this way: If you had our debt load, and you fell into a financial hardship, which debt is the hardest to overcome?
- Student Loans: You are able to defer your student loans in times of financial hardship. However, if you’ve consolidated your and your wife’s loans together, you BOTH have to have problems to be able to defer. Also, the student loan companies are generally willing to renegotiate your payment plan so that you can still make your payments without stopping them.
- Auto Loans: You can always sell your vehicle. In our case, I could sell the truck and we’d be down to 1 car. Or I could downgrade to something used at half the price. In your case, you may already have a dirt-cheap car, or may owe more on the loan than the vehicle is worth, but you can still sell it and reduce your monthly obligation.
- Credit Card Debt: What can you do for your credit cards? You can purchase a protector plan (for a per $100 balance fee). For a $10,000 loan, the average cost will run you $80-150 per month. Whoah! That’s not something the credit card company tells you when they offer this plan, is it?
Credit cards are the riskiest of the three debts because you have to PAY money to insure yourself against risk, while the other two have built in escape routes. Now, I’m not advocating for all of you to go ignoring your other debts over your credit cards, because in your scenario, paying down your non-credit card debt may make more sense. In our case, we want to be in a better position to handle future problems, or to make ourselves more open to opportunities if they come by (e.g. a great job offer back in PA).
So call me silly if you will, but this is my reasoning, and I’m sticking to it.
That’s the way I’d see it too.
Credit Card debt (no matter what the interest rate is), then Auto loans, then Student debt, then Mortgage.
For us, all of our loans were education-related. His was $7k or so in education from 4-5 years ago that he COULD’VE paid off but neglected to do so..
And mine was $47k in education debt on my end (yes… b-school was very expensive). We’ve managed to whittle it down to $41k in the last year, but the next 2 years are our power years and I’ve finally gotten in control of our expenses by tracking what we’ve been spending on a daily basis, and I feel confident that we can be free by June 2009 at the latest…. without any unforeseen expenses.
I agree that all debt hurts!
My hope is that my children and friends can see that there are ways to do everything without debt. They don’t have to, but at least know that they have choices. Things like college debt now a days is so common, people don’t even consider ways to buy stuff without going into debt.
On last comment now that you have sold the car debt, it should be much easier to sell the Honda. =)
My list is simpler.
Bad = my debt
🙂
Clever Dude…good one! I am about to write a post about Good vs Bad Debt and you definitely set a high bar.
Most student loan debt can’t be discharged in bankruptcy. Many students and former students would be lucky to have only $27,000 in student loan debt. I’ve got a friend with $100,000 in student loan debt. Also, car loans are secured debt, meaning the lender can take your car, sell it for you at auction for a deeply discounted price, and still hold the balance over you. “Selling your car” is not realistic. If your title isn’t clean you won’t be able to sell it for less than is owed unless you’re prepared to buy out the balance. But, miss a few payments and the lender will gladly sell it for you. The only debt you can truly dump if the situation gets bad (bankruptcy) is credit card debt. It’s unsecured. So, I respectfully disagree with you. Depending on your reader’s situation, it may be in their best interest to pay their non-dischargeable debts first, followed by secured debts, followed by everything else. Not everyone is in your position. Those closer to the edge would not necessarily benefit from your plan.
Furthermore, if you can afford to pay all your debts, why not do the math and get the best return on your money by paying off higher interest debts first? It’s an instant return on your investment. Thinking with your heart and not your head gets a lot of people into bad debt in the first place.
But, it’s your money so spend it as you see fit. I’ve been reading your blog for weeks but never posted. I wish you all the best.
Adam, thanks for the comment. I think you went a bit further than I had intended by saying the “B” word: Bankruptcy. I only intended some financial hardship, not total disaster.
Yes, I did intend for the seller of the vehicle that is worth less than the loan to have to cover the remainder, probably with a personal loan. That’s assuming their credit rating isn’t so bad that they can’t get an unsecured loan.
I’d say “don’t buy more than you can afford at the time”, but it’s easier said than done, as evidenced by my own history.
I agree, credit card debt sucks. Atleast with a car loan, you make a payment, then you go drive your car. With student loans you have a degree that will help you get a job to pay off your debts. With a credit card debt, you’re still paying for the VCR that no longer works, you’re still paying for meals that have long since gone the way of the toilet, and you’re still paying for the new tires on your car (which are beginning to become bald, and need to be replaced again).
I agree with the credit card debt. with the debt card we can easily go through car loan,bills,student loans,shopping.Most student loan debt can’t be discharged in bankruptcy. Many students and former students would be lucky to have only $27,000 in student loan debt. I’ve got a friend with $100,000 in student loan debt. Also, car loans are secured debt, meaning the lender can take your car, sell it for you at auction for a deeply discounted price, and still hold the balance over you.