Ranking The Best Passive Income Investments helps you strategize on developing retirement income. Over the years, the rankings have changed because economic situations have changed. In this post, I’ll be ranking debt types from worst to best.
When used appropriately, debt can help provide for a better life and make us wealthier. When used inappropriately, however, debt can destroy our lives.
The key is to always use debt in a way that positively helps get us to our financial goals in an as risk-appropriate manner as possible. In this incredibly low interest rate environment, the use of debt is going to increase.
Therefore, I think it’s important to come up with a framework for ranking debt today. We must be careful with our debt usage, especially during this time of uncertainty.
Debt Ranking Methodology
First of all, America is one of the most indebted nations in the world with a debt-to-GDP ratio of 107%. In the entire world, only about 5-10 countries have a higher debt-to-GDP ratio than ours.
Although America has more debt than GDP, at least we have the ability to print endless amounts of money and issue an endless amount of Treasury bonds to fund our debt. Debt is part of our culture, so we must embrace it.
To come up with my Debt Ranking, I use three variables:
- Interest Rate
Interest rate is simply the average interest rate of the debt. Purpose is what the debt is to be used for. Consequences are what happens when you get into too much debt and can’t pay it back.
Each variable will be rated between 1 – 5.
5 is great, meaning low interest rate, great purpose, and low consequences. 1 is terrible, meaning high interest rate, terrible purpose, and grave consequences.
Ranking Debt From Worst To Best
The Worst Type Of Debt: Payday Loan
I’m not sure why payday loans are still legal, but they still are in many states. A payday loan is a small, short-term unsecured loan with an extremely high interest rate. You can find payday loan shops in the roughest parts of town where they prey on people who are desperate for cash.
The term “payday” in payday loan refers to when a borrower writes a postdated check to the lender for the entire amount of expected pay and in return receives only part of that payday sum in immediate cash from the lender. A payday loan is also sometimes referred to as a “cash advance.”
According to debt.org, the average payday loan Annual Percentage Rate (APR) is a whopping 398%!
Part of the reason why the average payday loan interest rate is so high is that although payday loans are usually short-term in nature, their interest rate is calculated on an annual basis.
For example, let’s say you pay an $80 charge to borrow $400 over 14 days. That’s a 20% interest charge for 14 days. But on an APR basis, the math comes out to 541%. It should be clear as day now why payday loans are the worst when ranking debt types.
Getting a payday loan is like trying to escape the jaws of a sarlacc in The Return of The Jedi – hard to do! Many borrowers are unable to repay the loan in the typical two-week repayment period. When it is due, they must borrow or pay another round in fees, sinking them deeper and deeper into debt.
Bottom line: Stay away from payday loans! A payday loan is the worst type of legal loan out there. Payday lenders will attempt to lure you in and try to never let you out.
Payday Loan Score: 5
Interest Rate: 1. Worst interest rate of all debt types.
Purpose: 3. You’ve got to be pretty desperate to get a payday loan, hence, it might be for a good purpose. But perhaps not.
Consequences 1. Potential for financial ruin. A payday lender is as close to a loan shark as they come. Be prepared to be beaten up and harassed if you do not pay your loan back on time.
If you need a loan, it’s much better to get a personal loan than a payday loan. A personal loan will have a much lower interest rate.
Second Worst Debt Type: Credit Card Debt
It may surprise you that the next worst in my debt ranking is credit card debt. But I’ll tell you why. The average APR on a credit card is ~20%, even in this low interest rate environment. Some credit card APR go as high as 40% if you’ve got terrible credit. Not even the once great Warren Buffet can return the average credit card APY.
If you carry a balance, you are enabling credit card companies to rip you off. They’re secretly hoping you spend more than you make or forget to pay off your balance each month to earn billions in fees.
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.
Play the 0% APR balance transfer game if you must, however, you should pay down your balance transfer before the grace period expires. Otherwise, you may end up paying the entire interest owed for the entire duration if it is a deferred interest promotional transfer.
Please 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. When it comes to ranking debt you have to factor in the debt type’s interest rate, purpose, and consequences.
Credit Card Score: 6
Interest Rate: 2. Second-highest interest rate.
Purpose: 1. Spending is usually on unnecessary wants, not needs.
Consequences: 3. Late fees, credit score damage, a slower drowning than a payday loan.
Third Worst Debt Type: Auto Loan
Borrowing money to buy a depreciating asset is a bad move. Some people justify their auto debt by saying it’s so low at 0.9% or whatever low introductory rate. But 0.9% is still too much when you are guaranteed to lose money on a vehicle every month.
If you follow my 1/10th rule for car buying, then you shouldn’t have to go into automobile debt. To compound the financial pain by spending more than 1/10th your gross income on a car with an auto loan is foolish. All that money could have been invested instead.
Besides the rapid depreciation of a car, another reason why getting an auto loan is bad is that there are plenty of cheaper transportation alternatives. You can buy a cheaper car, ride the bus, carpool, ride a motorbike, bike, ride the train, walk, or take ridesharing. In other words, taking out an auto loan is a want more than a need.
In 2019, the average auto loan interest rate on a new car was roughly 5.76% according to Experian, and 9.4% for a used car. However, notice how high the average auto loan interest rate was for borrowers with lower credit scores. Yet, it is those borrowers who are most likely to take out an auto loan. In 2020, the average auto loan should be cheaper because the Fed slashed rates to 0% – 0.25% and auto loans follow the short-end of the yield curve.
Auto Loan Score: 9
Interest Rate: 4. The average interest rate is low and follows the Fed Funds rate.
Purpose: 2. A car is vital to get to work if you live far away, but most people don’t get a cheap used compact car. If most people did, most of the cars on the road would be 10-year-old Honda Civics.
Consequences: 3. Late fees, credit score damage, a slower drowning.
Additional Debt Rankings
Fourth Worst Debt Type: Student Loans
Education is what will set us all free. However, now that education is 100% free online, it no longer makes as much sense to take on student debt for a college degree.
Higher education creates artificial barriers to enable certain types of students in to create prestige and lock others out. But if educators really wanted to educate the world and make it a better place, they should let everybody in.
Further, after spending 4 years and hundreds of thousands of dollars, there is no guarantee you’ll get a job. It’s a good business model, but it also sounds like a racket, especially when universities keep charging higher tuition faster than the rate of inflation.
One of the great blessings of online media today is to be able to share experiences with others for free. Helping others is truly a gift that keeps on giving.
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 admit, I am highly biased towards state schools having attended The College of William & Mary for undergrad and UC Berkeley for business school. But I am also highly partial because I have witnessed plenty of college graduates graduate with nothing to show, except lots of debt.
If you still want to pay big bucks for college, it’s time to start asking your college for a guaranteed job in your major upon graduation. If there is no job, at least ask for a partial refund, if not a full refund.
Student Loan Score: 11
Interest Rate: 4. The average interest rate is low and follows the Fed Funds rate. The government can pause federal student loan payments, like it has during COVID-19.
Purpose: 4. Getting a college education is still one of the best ways to boost your lifetime earnings, however, you must do so prudently.
Consequences: 3. Late fees, credit score damage, loan cannot be expunged due to bankruptcy.
The Fifth Worst Debt Type: Friends & Family Debt
Borrowing from friends and family should be a last resort given there are so many ways to borrow money without potentially hurting your reputation. However, borrowing from friends and family is also one of the easiest ways to borrow money at a low interest rate.
Sometimes, you might just need a bridge loan. For example, you might have found a great house, but you can’t come up with the downpayment for another two months until your year-end bonus gets paid.
You don’t want to miss buying this house, so borrowing money from your parents in this situation is not bad. I’m sure your parents will charge you a low interest rate or no interest.
If you can borrow from friends and family and not ruin your relationship, borrowing in this manner is probably the easiest way to go.
However, if you have some doubt about whether you can pay your friends and family back, I highly advise against borrowing from them. Instead, ask if you can do some work for them for the funds.
Friends and Family Debt Score: 12
Interest Rate: 5. You can probably get the lowest interest rate available or not have to pay any interest rate at all. If you abuse the relationship, you may be able to get a free loan.
Purpose: 4. Only the most desperate of people ask their friends and family for money. Therefore, the purpose of the debt must be pretty important.
Consequences: 3. Generally, there are no consequences if you pay back the debt on the agreed upon terms. But if you do not, you will likely lose your friends and family.
The Sixth 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, but the American government also 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.
The government 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.
Having shelter is one of the fundamentals of life, along with food, water, and clothing. If you have a family, the value of having a home goes up further in value as you are housing more people with the same expense.
On the negative side, mortgage debt is usually one of the largest amounts of debt to take out. A $10,000 revolving credit card debt at a 20% APR is not much compared to a $500,000 mortgage at a 3% interest rate. If you get mortgage debt wrong, you can easily detonate all your financial progress made up to that point. Many people lost their livelihoods during the 2008-2009 financial crisis.
The government is pro-housing so you might as well take advantage. Don’t fight the government and don’t fight the Fed.
Now is the time to inquire online about the latest rates. Mortgage rates are at all-time lows in 2020+ due to coronavirus/recession fears.
The best place to refinance a mortgage is with Credible. With Credible, you’ll get no-obligation quotes in minutes from competing lenders so you can get the best rate possible. Ratings are inching up due to higher inflation expectations. However, rates will likely stay low for the rest of our lives.
Mortgage Debt Score: 14
Interest Rate: 5. Mortgage rates are still low because the 10-year bond yield is around 1.6%.
Purpose: 5. Shelter is a fundamental right. It feels amazing to provide for your family and live in a nicer home as you get older.
Consequences: 4. Late fees, credit score damage, debt can be expunged in bankruptcy. More banks are open to helping you pay your mortgage through a pause, a refinance, a recast, or a loan modification.
(Stock) Margin Debt
After I publishing this post, a number of people inquired about stock margin debt. Margin debt is when you borrow money from your brokerage house to make usually shorter term investments. You hope to make a profit large enough to cover the margin debt interest rate and then some.
The default account type is a cash account. To trade on margin, you have to specifically ask your brokerage to change your account to a margin account. Regulation T sets the initial margin at a minimum of 50%, which means an investor can only take on margin debt of 50% of the account balance.
If your account balance falls below the maintenance margin requirement, your brokerage will trigger a margin call and force sell your securities often at an inopportune time. They can and will do so without your permission.
I saw many friends lose everything during the 2000 dotcom bubble crash due to trading on margin. The same thing is going on in 2020. Greed and investing FOMO are extremely powerful forces. Everybody wants to get rich quick! But in the process of trading on margin, many people end up going broke instead.
If you want to trade on margin, limit this margin account to 10% or less of your entire investment portfolio amount. Set up a separate brokerage account to gamble. This way, if you lose everything, you’ll still be OK. In general, I think investing in stocks on margin is a bad idea.
Eventually Pay Off All Your Debt
Below is an overview of my debt rankings from worst to best. Each debt type is rated by Interest Rate, Purpose, and Consequences. I’d slot stock margin debt between Credit Card and Payday Loan. You could make money trading stocks, but you will likely lose money if you trade too much.
If used properly, debt can be wonderful because it enables us to live better lives. We just have to be careful not to borrow more than we can pay back.
I’ve used debt to get an MBA to further my career in finance. I’ve also used debt to be able to live in nicer homes since 2003. But I’ve also gotten in trouble when I went into debt to buy a vacation property in 2007. Buying a want and not a need is dangerous.
So long as you can afford to carry your debt load, you’re going to live a better life compared to if you had to pay for everything with cash. Just make sure you pay back all your debt before you retire or no longer have the desire or the ability to make money.
For those who don’t have debt, I commend you for living so fiscally responsibly. But to shun debt completely when you’re still trying to build your financial nut is a sub-optimal move, especially with interest rates this low.
Personally, I’m using mortgage debt to invest more in real estate in San Francisco. Meanwhile, I’m also investing in across the heartland of America through real estate crowdfunding.
Readers, do you agree with my debt rankings? If not, please explain your ranking. How have you used debt to your advantage? How has debt hurt you on your financial journey?