The Most Accurate Definition of Debt Ever

When you do a Google search for the definition of debt you will get that debt is money that you owe to another person or party and must pay back. While this is a good starting point, it is not the most accurate definition of debt.

Instead, a better definition of debt is the following. Debt is any financial obligation in which the only way you can pay it back is from money you have to earn. This may sound confusing so let's go over a few examples to try and clear things up.

Say that you had a credit card and were irresponsible with it and ended up in credit card debt. The only way that you can get out of this debt is to repay it. Under our definition of debt, credit card debt is a true debt. However, say that you just purchased a car and financed the purchase.

Would this car loan be considered debt? No, it is not true debt. If you have a car loan, there are two ways to get rid of the loan. First, you can pay off the loan. Secondly, you can sell the car. Since you can get out of the "debt" in another way besides repaying it, a car loan is not true debt.

When you sell the car, you now create a transportation problem, but you no longer have a debt problem. We will continue to develop this idea as it is contrary to the typical definition of debt provided by most of the financial industry.

Remember, debt is any financial obligation in which the only way you can pay it back is from money you have to earn. Under this definition, there are types of true debt that you want to be careful when using, or may want to avoid altogether.

1) Credit card debt -  Credit card debt is true debt as the only way you can repay it is to pay it back from money you have to earn. You might be able to transfer credit card debt to a lower interest rate, but at the end of the day you are going to have to pay back outstanding loans that you owe.

2) Student loans - Student loans are true debt as the only way you can repay them is to pay them back from money you have to earn. Student loans are not inherently bad as they are used to obtain an education which will hopefully provide a return of the back end. However, this is not always the case and student loans for some individuals can be substantial which can make them hard to repay.

3) Personal loans - Personal loans are true debt as the only way you can repay them is to pay them back from money you have to earn. Personal loans are loans that you can use for a variety of purposes including paying for a wedding, doing a home improvement project, and more. It is usually not a good idea to go pedal to the medal with personal loans as they are true debt.

False debt is a financial obligation in which you own a person or entity money, but can get rid of the debt without using money you have to earn. Defining false debt this way can help you better understand when it is okay to borrow money as long as you are careful.

1) Car loans - Car loans are an example of false debt. Although you borrow money when you have a car loan, you can sell the car in order to get rid of the loan. This of course creates a transportation problem as you no longer have a vehicle, but you no longer have a debt problem.

You can also find yourself in the situation in which the amount of money you can get from selling your vehicle will not cover the outstanding loan. This definition of debt might still sound counterintuitive, but we will continue to explain why it makes since later on.  

2) Mortgages - Similar to car loans, mortgages are false debt as you can get rid of the debt by selling the home. This of course creates a housing problem, but relieves your debt problem. Again, this definition of debt may not make much sense on the surface, but we will continue to explain its utility below.  

Having an accurate definition of debt will help you understand when it is acceptable to use debt and when it is not. Some individuals will argue that you should avoid debt altogether, but there are times when borrowing money is the right decision if you are careful.

The first indication that it is okay to use debt is when the debt is false debt based upon our definition of debt. Remember, debt is any financial obligation in which the only way you can pay it back is from money you have yet to earn.

If you can get rid of the debt obligation without having to use money that you earn, it is a false debt. The two most common examples of false debt are car loans and mortgages. It is acceptable to use a mortgage as most individuals would not be able to purchase a home without one.

It is also acceptable to use car loans under certain circumstances. Car loans can be beneficial, but they can also ruin your finances if you get a car loan that is too large for you to handle or has unfavorable terms. The question is when it is okay to use a car loan?

It is acceptable to get a car loan when you can get financing that is cheaper than what your money can earn from savings accounts or investments. For example, say that you have saved up $20,000 and are in the market for a car.

You are trying to figure out if it is best to pay cash for the car or finance the car. Say that you currently have the $20,000 sitting in a high yield savings account that pays a 5% APY. After shopping around for car loans, you get approved for a loan at 2.5%.

Since your $20,000 can earn more than it cost to finance the car, it makes sense to borrow money for your new car. Now this does not mean that you go and buy a brand new Porsche. You still need to evaluate your budget to see what car you can afford. We will look at this more later on.

On the flipside, say that the cheapest financing you were able to obtain for your car was 7%. In this scenario, it makes more sense to purchase the car in cash since your money can only earn 5%. When you pay cash for a car, there is one more step that you need to take that almost no one talks about.

You saved interest by paying cash for your car. However, you lost out on the interest that you could have earned from financing the car. What does this mean? Financing would have cost you 7% in interest. Since you had cash that earned less than that, it would not make sense to borrow money.

This was a good financial decision as you saved yourself 7% in interest payments by buying your car in cash. However, what did you lose out on by making this decision? You lost out on the opportunity for your cash to continue to earn 5% in interest.

Once you buy your new car in cash, you need to repay yourself the cash that you lost out on. In other words, act like you have a car payment at an interest rate of 5% (even though you do not) and repay yourself the money you lost out on. When you do this, you get the money back that you lost out on by paying cash for your car.

In general, you want to avoid or be careful to use any debt that meets our definiton of what true debt is. This would include credit card debt, student loans, and personal loans. Credit cards and student loans are not inherently wrong to use as both can provide benefits when managed responsibly.

However, when used irresponsibly, both can weigh you down financially. The reality is that many individuals that have credit cards and student loans carry a debt burden that they would like to get rid of. For example, Credit Karma found that their average member had a credit card debt of $6,469 according to a 2023 study.

Additionally, half of all students that graduate from a four year university graduate with student loan debt which can average between $30,000 and $40,000 depending on the data you look at. If you have both student loan debt, and credit card debt, it can be hard to get out of the hole.

So, what is the answer? As it related to credit cards, you have to ask yourself a question. Can you manage a credit card responsibly and pay off your balance in full each month? If you have a history of responsibly using a credit card and paying off the balance, it is perfectly reasonable to have a credit card.

However, if you continue to rack up credit card debt, credit cards are not going to be a good fit for you. You should use debit cards instead. Although student loan debt is becoming more common, it might be a necessity for you if a higher education is required for your desired career pursuit.

It is important to do everything you can to reduce the cost of college if you believe it is a necessity for you. This might include starting at a community college, living at home, earning college credits in high school, and more.
‍
Personal loans do have their uses, but it is usually not a good idea to get into more debt with a personal loan. If you want to use a personal loan to pay for a vacation or to improve your home, an alarm should go off in your head that is saying don't do it!

We will again reiterate our definition of debt. Debt is any financial obligation in which the only way you can pay it back is from money you have to earn. The reason that we define it this way is that it provides a framework on how to think through paying off debt.

The individuals who are in the "get out of debt wagon" argue strongly that borrowing money at any time is bad. However, not all debt is created equal. When you have an accurate definition of debt, you can better understand how to allocate your dollars.

If you have high interest debt that meets our definition of true debt, it should be a priority to pay it off. Credit card debt and personal loans are good examples of high interest debt. Credit card debt can easily have an interest rate of 20% or higher. The longer you carry this debt, the further into debt you will go due to the high interest.

There are cases in which you may have a true debt under our definition that has a low interest rate. An example of this might be student loans. For example, say that you graduated with $30,000 worth of student loans that have an interest rate of 4%.

You are trying to figure out if it is best to attack these loans with a vengeance or pay them off over a longer time period so that you free up money that you can do other things with. We are going to walk through an example that will help you think through how to tackle this problem.

For sake of example, assume that you have $552 to put towards your student loans. We are going to look at two different scenarios of how you could use this $552 each month to show what the better option is. We are going to look at these scenarios over a ten year time period.

For the first scenario, let's assume that you believe that it is best to pay off all of your debt as fast as possible. We know that you have $552 per month that you can use. You decide to take all of this money to pay off your student loans as fast as possible.

It would take you 5 years to pay off your student loans. Once you have your student loans paid off you feel relieved and decide to start investing for your future. Over the next 5 years, you invest $552 into the stock market.

Assume that you can get an 8% compounded return from the stock market. At the end of the 10 years, you would now have $38,360 as well as paid off student loans. Sounds pretty good right? Well, let's look at the second scenario to see if this is your best course of action.

In the second scenario you decide to pay off your student loans over 10 years as opposed to 5 years. This will lower your monthly payment which gives you excess money to invest. When you pay off your student loans over 10 years, your monthly payment is $304.

This gives you an extra $248 per month out of the original $552. You decide to invest this $248 into the stock market. Assume that you can get an 8% return from the stock market. At the end of 10 years, you would now have $43,112 from the stock market and your student loans would be paid off.

Simply by investing as you pay off your student loans, you would have almost $5,000 extra. Keep in mind that this is purely a hypothetical example. The point is to show that the best course of action is not always paying off debt as fast as possible.

Also keep in mind that this example is purely based on math. It does not take into account the psychological effects that debt can have on you. It is ultimately up to you to decide how you want to manage true debt that has a low interest rate.

If you have a false debt, such as a mortgage or car loan, it may not be your best course of action to pay it off as fast as possible. You have probably heard that paying off your mortgage as fast as possible will save you interest and is one of the keys to building wealth.

While it is true that you will save interest by paying off your home, it is not a complete analysis of the situation. By sending extra dollars to pay off your house faster, you lose the opportunity to have your dollars earn interest in other areas.

For example, say that you just bought a $400,000 home on a 30 year mortgage that has a 4% interest rate. After reviewing your budget, you estimate that you can send an extra $2,500 to the principal of your mortgage per year.

By sending an extra $2,500 to your mortgage principal each month, you will pay off your mortgage 5 years early and save $53,548. This probably looks like a good decision. You no longer have to make a mortgage payment and save yourself over fifty grand.  

However, this is not a complete analysis. The alternative to sending an extra $2,500 to your mortgage is to invest the $2,500. Say that you decide to do this and will invest the $2,500 into the stock market over the course of your 30 year mortgage.

Assume that you can get a return of 8% over the 30 year period in the stock market. At the end of the 30 year period, your investments would be worth $282,754 using the assumptions listed above. So, you need to ask yourself a question.

Would you rather pay off your mortgage in 25 years and save $53,548 in mortgage interest or would you rather pay off your mortgage in 30 years and have $282,754 worth of investments? The point of this example is to illustrate that paying off a false debt as fast as possible is not always your best course of action.

If you plan to pay off a false debt early, you need to ask yourself if the extra money you are going to put towards the false debt can be better utilized in another area.

The first step to managing debt is to take a step back and look at your entire financial picture. If the goal is to avoid true debt, you need to put safety measures into place. The two primary safety measures are having a well funded emergency fund and having proper insurance coverage.

An emergency fund is a liquid reserve of cash that you can access to pay for unforeseen emergencies. For example, say that your car breaks down unexpectdely and a mechanic tells you it is going to cost $2,000 to repair it.

If you don't have any savings, you might have to put the expense on a credit card which could send you on the fast track towards debt. If you build an emergency fund, you can avoid having to use true debt to cover unexpected expenses.

Having proper insurance coverage can also help you avoid going into debt. For example, say that you rent an apartment and a fire breaks out. If your personal property is damaged and you don't have renters insurance, you might have to go into debt to replace your personal property.

If you do have renters insurance, your policy would pay the cost to replace your personal property. Having safety measures in place that will protect you from going backwards financially is a key to managing debt.  

While it is important to have a plan to manage your debt load, it is equally important to set yourself up for your future. You can do this by investing. There are lots of ways to invest, but an easy way to get started can be by opening up a Roth IRA.

If you want an automated approach to investing, you can also use a robo advisor. The point here is to not become so obsessed with debt that you forget to set yourself up for your future. It will not matter that you managed debt well if you are old and have no money.

Once you have safeguards in place and understand that it is important to invest for your future, you can manage your debt load with the money left in the middle. The question is how do you do this? You do this by first understanding what true debt is.

True debt is any financial obligation in which the only way you can pay it back is from money you have to earn. Your first focus to managing debt is to pay off high interest true debt. This would include credit cards and high interest personal loans.

If you have a true debt that has low interest, it is not always best to focus on paying that debt off as fast as possible as detailed throughout this article. If you have a false debt, such as a car loan or a mortgage, you need to ask yourself a question.

Is it best to pay off these false debts as fast as possible by sending extra payments to them, or can I get those dollars to work harder than the debts by investing them? Asking yourself this question will help you know where to allocate your available dollars.

It is by no means wrong to live life debt free. For some individuals, it is what is best. The reality is that many individuals cannot manage debt and should not borrow money. If living a debt free life helps put your mind at ease, you should do that.

The point of the information above is to show that borrowing money can be a smart financial decision at times. Debt is often demonized as the reason that individuals cannot achieve financial success. At times, this is absolutely true.

However, if you immediately jump to the conclusion that living debt free is better than understanding debt, you may miss out on financial solutions that can improve your life. When you understand what true debt is, you can make much more informed financial decisions to help you reach your goals.

The bottom line is that debt is any financial obligation in which the only way you can pay it back is from money you have to earn. By defining debt this way, you can begin to understand when it is acceptable to borrow money and when it is not.