Ranking Debt Types From Worst To Best

When used appropriately, debt can help provide for a better life and make us wealthier. When used indiscriminately, however, debt can destroy our financial lives. This post will rank debt types from worst to best in order to help you achieve financial freedom sooner.

To start, let's say where America stands compared to other countries regarding how much debt we have. Below is a list of the most indebted nations according to Trading Economics. Currently, America is at ~104% debt-to-GDP and historically ranged from a low of 31.7% to a high of 122%.

Whenever your country's debt is greater than its GDP, it's a good idea to encourage your politicians to exercise fiscal restraint lest they take your country to hell during the next financial crisis.

Notice how many of the most indebted countries such as Greece, Italy, and Portugal continue to struggle since the 2008-2009 financial crisis. Japan and Singapore are different animals since they are a huge net exporter.

Debt To GDP Ratio By Country
Source: Trading Economics, Debt-to-GDP ratio by Country

Let's review the following types of consumer related debt and rank them from worst to best. We'll also take a look at the latest interest rate by debt type.

Ranking Debt Types From Worst To Best

Now let's go through the different debt types from worst to best. The worst types of debt should be paid off first.

The Worst Type Of Debt: Payday loans

Payday loans are terrible. They are marketed towards the poorest people in society and often trap them in a cycle of dependency. Payday loan interest rates can run over 100% a year.

Payday loans give people who run out of cash a loan to pay their bills. Payday loans are a short-term loan that should last only a month or two. However, roughly 80% of payday loan borrowers are repeat customers.

Odds are, if you don’t have enough money to pay rent this month, you won’t have enough money to pay rent next month. Please avoid payday loans at all cost.

The Second Worst Debt Type: Credit Card Debt.

When ranking debt types, credit card debt is almost as egregious as payday loans because credit cards are so easily accessible. The average APR on a credit card is ~15%. Some go as high as 29.99% if you've got terrible credit. This is such a ridiculously high interest rate which not even the annual returns of the great investor, Warren Buffet, can match.

If you carry a balance, credit card companies are ripping you off. They're secretly hoping you spend more than you make or forget to pay off your balance each month. No Financial Samurai should ever have revolving credit card debt. Use a credit card for rewards points, insurance, a free 30 day loan, and concierge service, but that's it.

I highly recommend reducing the time spent playing the 0% APR balance transfer game. Instead, focus on making more money instead. Don't use the credit card as a crutch to support irresponsible spending habits. Credit card debt might very well be equivalent to payday loans and loan sharking debt.

Average credit card interest rate
Average credit card interest rate from 100 cards compiled by CreditCards.com

The Third Worst Debt Type: Automobile debt.

Borrowing money to buy a depreciating asset is a really bad move. And cars are notorious for losing value as soon as you drive it off the lot.

Some people justify their auto debt by saying it's so low at 1.9% or less. But 1.9% is still too much when you're losing money on a vehicle every month.

If you are able to spend 1/5 – 1/10th of your gross income on a car, then you shouldn't have to go into automobile debt. If you buy a car that's 1/5 – 1/10th your gross income and can get a 0% loan so you can invest the difference, then fine. Otherwise, just say no to automobile debt.

Current automobile interest rate loan - Ranking debt types from worst to best
Source: Bankrate.com

The Fourth Worst Debt Type: Student loans

Student loan debt is not that bad given education is the key to building wealth and pursuing your dreams. When you have the knowledge and skills to make things happen, life gets so much easier. That said, there's nothing you learn in college that you can't learn for free on the internet. Therefore, skyrocketing college tuition seems more like a scam, especially since higher tuition doesn't guarantee you a well-paying job upon graduation.

Unless your family is rich, choose a college that provides enough free grant money so that you'll be able to pay everything back within four years of graduation. I'm highly biased towards state schools having attended The College of William & Mary for undergrad and UC Berkeley for business school. 

You can deduct up to $2,500 of student loan interest paid in any given year if your modified adjusted gross income is under $80,000 or $160,000 for married couples filing jointly.

Related: Pay Down Debt Or Invest? Implement FS-DAIR

Average student loan interest rate
Average student loan interest rate. All rates are fixed for life of loan. Source: studentaid.ed.gov

The Fifth Worst Debt Type: Mortgage debt

Mortgage debt is considered the least egregious debt because it's tied to an asset that historically appreciates in value. Not only that, the American government allows you to write off all mortgage interest on debt up to $750,000 after the Tax Cut And Jobs Act was passed in 2018. Some say mortgage debt is actually considered good debt.

The government also allows for tax free profits of up to $250,000 for individuals and $500,000 for married couples if you live in your property for two out of the last five years. Finally, the government allows you to defer taxes by allowing you to use the sale proceeds to buy another property under the 1031 exchange program.

Take a look at this US housing price chart by Zillow and The Economist. The clear trend is up and to the right with some cyclical downturns on the way. The massive gap in price performance between Dallas / Houston and other major cities is one of the biggest reasons why I'm buying heartland real estate through real estate crowdfunding.

With the remote work trend, technology, and strong job growth, I believe the spread will narrow. Investing in real estate crowdfunding is going to be a decade-long investment trend.

You want to be on the right side of a tank, inflation, the Fed, and the government. The government is pro-housing so you might as well take advantage. You'll want to pay off your mortgage before you no longer have the desire or energy to work. Mortgage rates are still low, but have creeped up since their 2020 lows. For a no-obligation rate quote, check with Credible, my favorite online lending marketplace.

Leverage Debt For A Better Life

For those who don't have debt, I commend you for living so fiscally responsibly. If you never have debt, you can never get into too much financial trouble.

But to shun debt completely when you're still trying to build your financial nut is a sub-optimal move. If you can borrow for cheap and earn a greater return on your money, such arbitrage should be pursued until you have enough. By ranking debt types, you can better utilize debt to grow your wealth.

Post-pandemic, interest rates have declined. If you can take on a mortgage to buy a house, you will likely build wealth over time. The reason being is that your mortgage is fixed and gets paid back with inflated dollars. Meanwhile, your house tends to appreciate at the rate of inflation or higher.

I'm especially positive on the housing market post-pandemic. A house has become a much more valuable asset because we're all spending so much more time at home. The work from home trend is here to stay. Further, the value of rental income has gone way up because interest rates have come down. In other words, it takes more capital to generate the same amount of risk-adjusted income.

Recommendations To Build Wealth

In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. Now post-pandemic, there's a huge demographic trend towards lower-cost areas of the country.

Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the way to go. 

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio. 

About the Author:

Sam Dogen began investing his own money ever since he opened an online brokerage account in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at two of the leading financial service firms in the world. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. 

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