other second mortgage borrowing. Cars also are relatively long-lived purchases, so car loans at reasonable interest rates make sense if the length of the loan is less than the length of time you expect to own the car. But borrowing for consumables—clothes, dining out, entertainment, and travel—is likely to get you into trouble and hinder reaching your investment goals. I would consider a credit card balance with a high interest rate as “bad debt.”
Indebtedness is both an economic issue and a peace-of-mind issue, so the following are some other important debt considerations to weigh.
Are You Mortgaged to the Hilt?
For most people, the single biggest debt obligation is a mortgage. The question here is not whether to have a mortgage—few people could buy a house without one—but how to minimize the weight of that debt. Many people view their home as their biggest investment, hoping that it will appreciate in value and help to finance their retirement.
But the debt issues of homeownership sometimes get overlooked. Taking out a big mortgage in order to buy an expensive house could create a debt burden that you'll regret later. What's more, you might become house poor, meaning that the expenses associated with home- ownership preclude you from spending on other things or, more importantly, saving.
You can measure your mortgage burden by calculating your loan-to-value ratio. Think of the loan-to-value ratio as the percentage of your house that belongs to the mortgage company instead of to you. Suppose that at age 30 you buy a home for $250,000. You make a down payment of $25,000 and take out a 30-year mortgage for $225,000. Your loan-to-value ratio is 225/250, or 90%, because you've paid for only 10% of the house's value. As you make payments over the years, you will steadily build up equity in your home, and your loan-to-value ratio will decline. If your home also grows in value over the years, the ratio will shrink faster. Suppose you still own the house when you're 50 and your remaining mortgage is $125,247, but the house is now worth $350,000. Your loan-to-value ratio is just 36%.
Most homeowners don't worry much about their mortgage debt because they count on their house rising in value over time. It doesn't always work that way. The bursting of the housing bubble in 2007 was one of the key catalysts of the Global Financial Crisis and led to a tidal wave of foreclosures. Here's what happened. Housing prices were on the rise. Relaxed lending standards enabled many individuals to purchase a home, and many overextended themselves. When housing prices then declined dramatically, many homeowners found themselves upside down, meaning their home was valued less than their mortgage. Some had trouble making the monthly mortgage payments; others became forced sellers in a down housing market.
Returning to our example, consider the home you purchased for $250,000 is now worth $175,000, or 128%! With a mortgage of $225,000, your loan-to-ratio is 225/175. Consider a house a place to live, not an investment. If you are fortunate, it will rise in value over time, but don't bank on it.
If you are in a high-risk profession that is subject to industry downturns and periodic layoffs, it is sensible to avoid a heavy mortgage burden because you don't want the fixed cost of a large monthly mortgage payment if you are out of work for a time. But if you have some reasonable level of job security, you may not be as concerned about the size of your mortgage. The point is that you should think about your personal situation before taking on a mortgage or other major debt.
Are You Carrying Credit Card Debt?
If you have high-interest credit card debt, you should pay it off before you begin investing. Some people think it makes sense to start investing even though they are carrying balances on their credit cards. They hope to come out ahead by earning returns on their investment that exceed the interest they are paying on their debt. But you'll see the danger in this approach if you think about it.
Most credit cards charge interest rates that are 15%–18% or higher. To earn even higher returns as an investor, you'd have to be investing in stocks, and you'd have to be picking investments that beat the long-term average annual gains of 10% that stocks have earned over the long run. The odds aren't very good that your investment will do that in a one-year period.
There's an additional danger in thinking that you can get ahead as an investor in spite of credit card debt. When you do this, you are hoping that the short-term returns on your investment (a big uncertainty) will offset debt payments that are a certainty. No matter what the market does, you will still have to make those credit card payments.
I can think of just one situation where it would make sense to start investing before you have paid off credit card debt. If your employer matches contributions to your 401(k) plan, you should get started in the plan right away, while of course paying down your debts as soon as possible.
Are You Investing with Borrowed Money?
For the same reason that credit card debt and investing don't go well together, it's never wise to invest with borrowed money. It's a certainty that you'll have to repay the money you borrowed. It's never certain that you'll receive the investment returns you're hoping to receive.
In the day-trading frenzy of the 1990s, some investors began buying stocks with borrowed money. The practice, which is called buying on margin, is very risky because it magnifies the impact of gains and losses. If the margin investor's holdings suddenly drop in value, he is often forced to sell the stocks that serve as collateral to pay off the loans immediately.
What this means is that debt with an after-tax cost of 4% is not a terrible thing if you are earning a 5% after-tax return on your investments and you can deduct the margin interest. But you're not getting ahead financially if you're earning after-tax returns of 5% a year on your investments at the same time that you are paying 19% on your credit card balance.
The tax aspects of debt are worth thinking about, but don't get so hung up on them that you squander time and energy finding ways to profit from having debt. The peace-of-mind issues are as important as the numbers.
Are You Counting Your Chickens Before They Hatch?
Suppose you've watched the property values climb in your neighborhood, and you're considering refinancing your mortgage to take advantage of that appreciation and get some extra cash. Or perhaps you've accumulated a tidy nest egg in your 401(k) account and now would like to borrow on it. Be very careful.
It's true that sometimes these decisions make good financial sense. But keep in mind that borrowing against your house or your 401(k) carries a risk. The appreciation in a house or a 401(k) is just a paper gain, not money in your pocket. You won't truly have real money in your pocket until you sell the house or withdraw money from your 401(k) plan. The risk is that property values or the financial markets will fall, and you'll be left owing money. If you have the misfortune to be laid off from your job and you have borrowed against your 401(k), you will have to keep repaying the loan while unemployed or face additional taxes and penalties.
Know What You Don't Know
The final point about financial planning: Know what you don't know. Yes, there is much that you can do on your own in setting up a financial plan and beginning an investment program, but it's also important to have some humility about other elements of your financial needs. I'll just make a few comments here because so much of it depends on your personal situation.
Life and disability insurance planning is one area in which professional advice is often worth the
