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As I broach this emotional topic, I want to begin by being clear. I am neither for nor against debt. Debt is amoral, meaning, it is not in and of itself, categorically, moral. Debt can be a destructive evil. It has torn people down and has caused heartache, divorce, and all sorts of strife. Debt has also built churches, businesses, and hospitals that have been used for incredible good. Debt is neither right nor wrong categorically.
To understand different sorts of debt, we must first understand assets.
Imagine for a moment you are in your backyard and you have a shovel. You decide that you’re going to dig a hole big enough for a pool. You begin digging this hole, and beside the hole, you make a pile of the dirt that you’re removing. As you get about halfway through, you realize that you’re no longer going to be able to afford the pool, so you fill the hole back in and before long, your back yard looks just like it used to. No hole and everything is back to normal. No harm, no foul, right?
Now imagine the same scenario, but this time, instead of putting the dirt beside the hole, you had a dump truck take the dirt away as you filled it. Again, halfway through digging the hole, you realized you weren’t going to be able to afford the pool. But this time, the dirt is gone. You have a massive hole in your backyard and you don’t have any dirt to fill it in. You’re stuck. In this scenario, it’s not no harm, no foul. You have a massive hole that is not only an eyesore, but it’s a liability. Someone could fall in and hurt themselves. What started as a harmless project has become a massive problem.
This story shows the difference between asset backed debt and unsecured debt.
In the first scenario, the hole you are digging is your mortgage. You are taking a loan out on your home and now have a proverbial hole. But beside the hole, is the dirt to fill it in, or the asset which caused the hole in the first place. If for some reason, you were no longer able to afford that mortgage, you could most often sell the house, your asset, and the hole would be filled in. If the dirt is beside the hole, the hole is a lot less risky. In other words, if your asset, your home, is greater than your mortgage, you’ll have no problem filling in the hole if needed. You’ll be able to sell your asset, pay off your mortgage, and be left with a flat backyard.
In the second scenario, I am talking about unsecured debt. This sort of debt isn’t secured by an asset, in other words, there’s no dirt to fill back in the hole. This is the person who digs a hole with a credit card. They spend money on that fancy vacation or that nice dinner out. By swiping the card, they are digging a hole. But the dirt is vanishing into thin air. As they look at their credit card balance, they realize that they have a substantial hole in their backyard, but there is no dirt beside the hole to fill it in. This person can’t sell their vacation they already went on or return the meal they already ate. The dirt is gone, and they’re left with a hole that is a liability and a burden. It isn’t going to fill itself, so over the next several years, this person must work to earn more dirt to fill the hole back. This is unsecured debt.
Now that we have a better understanding of asset backed debt versus unsecured debt, next week, I am going to begin walking you through standards around mortgages, cars, credit cards, and personal loans. These standards will all stem from the principle of the dirt and the hole, so make sure you read next week in light of this week’s column.
Zach Santmier is the owner of Trumble Agency, Inc. and the author of the personal financial course, Increase. He focuses on helping families escape paycheck to paycheck living so they can freely pursue their ideal future.
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