Exjackly

This is part 3 of a series talking about bad debt. The parent post is at What to do about Bad Debt. Part one can be found at What to do about Bad Debt and part 2 is at The Terms of Bad Debt.

This post talks about how Too Much of a good thing can be enough to turn an otherwise good debt into a bad one.

There are really two ways that Too Much can be bad financially. The first is when an alternative would help you become wealthier faster. The second is when too much is truly more than can be afforded.

Too Much - Better Alternatives

Using credit can improve your investment returns by increasing your leverage. Forbes.com has a good articles title Burdening Your Retirement With a Mortgage that talks about the risks of leverage. For a Canadian point of view, you can try leveraging - the basics at RRSP.org (Warning: several acronyms in the post are not defined and may be confusing). Not to ignore anybody across the pond, try this link to The Uncarved Blog, Having a Mortgage post.

Few people would argue that a mortgage, in general, is a bad debt. Encouraging people to get a home by using a mortgage is even considered conventional wisdom and there are many programs designed around helping first time home buyers through the process. Unfortunately, this home ownership push could use more scrutiny.

Take a look at this table:

Rent vs Buy

What it shows is a very simple comparison of the rent vs buy debate. Column by column we have:

• Rent - This is the cash outlay a renter would expect to have over the given time period.
• Buy - This is the cash outlay a homeowner would expect to have over the same time period.
• Total Difference - This is the total difference in cash outlay between the two, with simple interest of 5% per year.
• Equity - This is the amount of equity the homeowner would have at the end of the time period, assuming 5% annual gains in the value of the home.
• Rent Value - This is the difference between the Total Difference column and the Equity column. Essentially, this is how much ahead the renter is on paper. It does not include sales cost for the homeowner.

Now, feel free to jump all over me for the assumptions I made if you want to. This is intended to be a simple example using low, but comparable numbers.  One thing I would like to emphasize is that variations in rents, interest rate, home appreciation rates, tax rates, and market performance can change the result of this evaluation.  For another writeup on the rent vs buy debate, head on over to InvestorGeeks and read Misconception: Renting is for Suckers.

This example highlights that conventional wisdom is not always correct.  In this case, for somebody who moves frequently or wants a significantly larger amount of free cash flow, renting IS the way to go.   It is important, even when applying rules of thumb and conventional advice, to check the specifics and make certain that your choice is the right one.

Remember, what is best for somebody else has absolutely no bearing on what is best for you.  You are unique, your financial situation is specific to you and general advice is no better than asking people on the street what you should do.

Too Much is More Than Enough

It is possible to have a plan that is overall good for your health, but a bad plan because you will never get to the payoff at the end.

Examples of this are all too common.  Even without the current increased level of foreclosures in the housing market, there are many homeowners who bought more house than they should have.  The large payments require them to cut back or eliminate other areas of their budget, severely limiting their quality of life.

Likewise, choosing to take on multiple debts, each of which is reasonable on their own, can quickly mount to overwhelming proportions.   Take student loans, add a mortgage to it, throw in some credit card debt from having to move yourself to start your new (higher paying) job and it can be a lot for a budget to absorb.  While each of these are reasonable (one would hope you had an emergency fund to pay for the move, but not many have one coming out of college) together they are huge.

This brings up the last point I want to make about Too Much: every financial commitment that is made has to be considered in the full context.  If every financial obligation is included in choosing to add a new commitment (like buying a home) it is much easier to make a wise decision that will maximize your financial well being.

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