Is Debt Bad?

Financial Literacy Education-

Educator Training-https://www.nku.edu/academics/cob/Professional-Development/Teaching-Financial-Literacy.html

Student Resources- http://onlinecatalog.nku.edu/preview_course_nopop.php?catoid=9&coid=18853

Total Money makeover- https://amzn.to/3eFdQnZ

Transcript

Debt isn’t bad, not knowing how to use debt is bad. 

Telling people to avoid all debt because they may struggle to deal with it does not solve the underlying problem. Debt is not the issue, the real issue is that we are not taught how to properly manage debt. 

Today on Coffee with Dr. A we are going to discuss why advising people to avoid debt is bad and why using debt can improve your positioning in life.

Hi everyone, my name is Dr. A, I'm an economist at Northern Kentucky University. I am also an advocate for financial literacy education. On this channel we talk about economics and how it can help you make better decisions in life. 

Go grab a cup of coffee and let’s talk about personal debt. 

Dave Ramsey is a personal finance radio personality and a New York Times best selling author. He has a large following of listeners and he has developed a financial curriculum that is popular, it is starting to make its way into high schools. While his book, 7 Baby Steps might help some that are in financial trouble, his advice is not for everyone. Sadly, it is often presented as financial literacy education for all. I, specifically, do not agree on the advice to avoid debt or the discussion on how debt is BAD. 

I want you all to know that debt is not bad. What is bad is mismanaging debt. Like everything in life, you must learn and understand debt before you start using it. Debt or “the amount of money borrowed by one person from another”, is a tool for you if used correctly. The most common usage for debt is when a person needs to make a large purchase that they could not afford under normal circumstances, not because they don't have the money, they just don't have all of it now. The borrower agrees to pay back that borrowed money to the lender over a fixed time with some added money. That added money is called interest. 

Dave Ramsey’s suggestion that we should avoid debt at all costs means that we will never teach people how to use debt effectively. Limiting people’s access to debt markets can harm your overall life trajectory. To better understand why debt is an important tool for you, I want to discuss a topic called consumption smoothing or the “life cycle” theory of saving and spending.

Consumption Smoothing

During a person’s lifetime their income follows a hump shape. When you are young, your income is low. Your income begins to rise the older you get and typically peaks during middle age, then your income falls again when you enter retirement. If you stuck to the no debt rule, , aka the Dave Ramsey approach, your consumption would be very low at the beginning, high during the peak and then low again during retirement. Realistically, you want to “smooth” out your consumption throughout your entire lifetime.

Through consumption smoothing, during your early years with a low income, you take out student loans to attend college or take out a mortgage to buy a house. Then when you transition into your middle years, your income will increase and you can pay off your debt while also saving for retirement. This middle phase is often referred to as the “saving phase”. Once you reach the retirement phase your income falls again and you use your retirement savings to level your consumption out.  

So how do we determine what our consumption should be? This is determined by the permanent income hypothesis.This hypothesis states that consumption doesn’t depend on how much you earn today but how much you are expected to earn over your lifetime. Those that expect to have high lifetime earnings will have higher consumption than those with expected low lifetime earnings. Individuals smooth their consumption as a function of permanent income. In early years they take on debt, and pay it off later. So now debt is being used as an important tool. 

Debt gone wrong

We all know someone, or maybe it was us, that mismanaged debt. Dave Ramsey’s advice on why to avoid debt is based on his own personal bad management of it. Let’s talk about how debt can be mismanaged 

First, since we base our consumption on the permanent income hypothesis, we might have incorrect expectations of our permanent income and consume more than we should during earlier years and go into too much debt. Some common mistakes on why people overestimate their permanent income are due to  mistaking their gross income for net income by not taking taxes into consideration or not researching their career paths well.  These mistakes and more can be solved with better financial literacy education and better career development.  

Other ways we can mismanage debt are not knowing how much debt we have or misunderstanding repayment schedules, interest rates, or not reading the fine print. These are  common issues with student loan debt. From my experience, most students do not know how much debt they have accumulated, what interest rate applies to the debt, or the repayment schedule. Student loans are a valuable tool to develop your human capital, but if you do not know how it works you can easily take on too much debt. Once again, financial literacy here is helpful.  

How to use debt

It can be easy to lump all types of debt into a “bad” category as Dave Ramsey does, but there is good debt and bad debt. Good debt can help you build your wealth. Debt should be used to help you build up your long-term wealth. Student loans are often a form of good debt. Gaining a college degree usually equates to higher earnings throughout your lifetime than without a degree. Home mortgages are often presented as a form of good debt, but that can depend on your financial situation. I probably should make an episode about the pros and cons of homeownership. Leave a comment and tell me if you would be interested in that video. 

Another place debt is helpful is with small businesses and entrepreneurship. According to the Small Business Administration, 44% of the U.S GDP comes from small business and two thirds of new jobs are created by small business. Most of these businesses require the use of debt to start. Eliminating debt would stall America’s economic engine, small businesses. 

While I disagree with Dave Ramsey’s larger picture of debt, I do agree with him that mismanaging debt is harmful. For instance, You should not use a credit card or take out debt to make purchases on items that depreciate in value. Learning how to navigate the debt markets is an important tool and we must teach people how to make better decisions with debt. Avoiding debt is not good advice, and it is not realistic. 

Whether you are a student in high school, college, or an adult who is not comfortable with your finances go check out my video on “How to Budget Better” where I discuss the 50-30-20 budgeting rule and better ways to break down your budget. I also recommend that you take a financial literacy course. For students in high school or college many schools have introduced their own financial literacy courses. If you are out of school or your school doesn't offer a financial literacy course I will provide some suggestions of my favorite online courses and other resources on debt and better debt management in the description below. Let’s not be scared of debt. It is a valuable tool at your disposal. Use it to grow your wealth, don’t let it drag you down.