Any single debt decision is probably insufficient to destroy a family’s financial situation. However, when families fail to manage debt from a holistic perspective and do not quantify and understand all sources of household debt, they tend to take on debt in a manner that eventually snowballs into financial insecurity. There is often a focus on credit-card debt because the interest rates are very high relative to other types of debt. Also, credit-card debt can be more salient for families since having too much of it can preclude further borrowing.
Yet, credit-card debt is not the only critical component of household debt. There are other significant sources of debt that can lead a household down a path to financial insecurity. First mortgages, in contrast to home-equity loans (2nd mortgages), have several benefits over other types of debt. First-mortgage interest payments are tax deductible. First mortgages give households the option of refinancing, if overall mortgage interest rates decline and financing conditions become more favorable. First mortgages also allow home buyers to build equity.
Despite the relative benefits of first mortgages, the decision to buy a home with debt should be considered carefully. In most cases, one should consider buying a home only when planning to stay in it for several years. As a general rule, households should not take a mortgage in which they cannot afford the monthly payment. Problems arise when the cost of the home (including taxes, maintenance, and other costs) exceeds 28 percent of monthly income.
Failing to understand the risks associated with adjustable-rate mortgages (ARMs) can also cause problems. With ARMs, there is a risk that overall interest rates will increase and correspondingly, the household’s monthly mortgage payment. Furthermore, when moving from one home to another it is not advisable for a person to put his/herself in a position in which (s)he must carry two mortgages. Most households cannot afford to have two homes (even for a short period of time).
This was one of the issues that contributed to Gabler’s financial insecurity. Home-equity loans do not have the same benefits as first mortgages. While the homeowner is still using the home as collateral for the loan, (s)he is not building equity. Furthermore, interest rates for home equity loans are generally significantly higher than for first mortgages and the interest payments on home-equity loans are not tax deductible.
One big (underemphasized) debt mistake that households often make is borrowing against a retirement account. This can be problematic because there are significant costs and risks associated with this.
Moreover, it is important to start saving early for retirement and this critically undermines that objective. In the article, Gabler mentions borrowing from a 401(k) to finance his daughter’s wedding. While the sentiment to give one’s daughter a great wedding is laudable, this is not necessarily the best financial decision. The best gift to give one’s daughter would be parents that are financially secure in old age and are not a financial burden to her or her family. Borrowing from a 401(k) account should be a last resort option for emergencies only.