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Having Debt vs. Being in Debt

In many circles, even personal finance ones, debt has a multitude of definitions and connotations. There are thousands of opinions about how much debt you should carry and when. Most agree on the general definition, where one party borrows money from another and agrees to pay the second party back, often with interest. Then, there’s this idea where if you have any debt, you are “in debt.”

It is my opinion that just because you have debt, it doesn’t mean you are in debt. Two factors contribute to the distinction. The first is whether your liability is less than the value of the asset you have the liability on. If this is the case, then the impact on your personal net worth is net positive as it relates to that asset. The second factor has to do with how difficult it is to make the payment on the loan. If you can live a modest life without sacrificing any necessities and without sacrificing all (or even almost all) luxuries, then you are not in debt. Let’s examine a few different kinds of debt to test the two factors. If a debt fails either test, then the debtor is in fact in debt.

The best place to start is with the largest debt that most people will ever have: a mortgage. (And let’s also get out of the way that there is no right or wrong answer to having a mortgage on a home. There are advantages and disadvantages to borrowing to buy a home, to owning a home outright, and to renting, and all are dependent on a person’s risk tolerance and stage in life. I digress.)

If you owe less on your house than it is worth, then it passes the first test. You owe the lender/bank money, but if you have the cash flow every month to comfortably pay your mortgage (around 20% of your income), then the mortgage passes the second test you are not in debt. You have a debt, but you are not in debt.

Moving on then to student loans. This one is not as simple as a mortgage because we can’t use the first test. It’s difficult (though not impossible in most cases) to tell if your education is worth more than you owe on it, so we must fall back on whether you can service this debt comfortably or not. If you can live life without inordinate sacrifices, then you are not in debt, however, if your student loan payment is impacting your quality of life, you are in debt.

Up next are auto loans. We can ask a similar question here as we did with the mortgage: do you owe more on your car than it is worth? If so, you are in debt. The loan on your vehicle is contributing negatively to your net worth. If your car is worth more than you paid and you can comfortably service this loan payment every month, you are not in debt.

Lastly, let’s examine credit card debt. Almost everything you buy with a credit card is worth less than you bought it for, whether it’s entertainment, food, clothing, furniture, etc., so credit card debt fails the first test. Whether the credit card payment is easily paid or not is a gray area as well because it’s possible to be making payments while the balance is still growing. A credit card payment can only truly be at a comfortable level if you are able to live a normal life while paying down the balance. Unfortunately, in most cases people with credit card debt have failed both tests: everything they purchased is worth less than they paid and making the credit card payments negatively impacts their life.

There are no absolutes when it comes to debt. Despite popular opinions, not all debt is bad, and not all home loans are good. When trying to decide whether to take on a new loan, see if it will put you into debt. Also remember that the fewer payments you have, the more cash flow you can generate every month. More cash flow means more opportunities for investment and reaching your goals.

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