All Debt Carries Risk, but Not All Risk is Equal

Problem #33: What Am I Risking with My Current Debt and Am I in Danger of Losing it All?

What is risk, and why should I be concerned about it? If you’ve never evaluated your financial risk, now is the time. This is very important and should not be overlooked. Not being aware of your financial risk can be a PROBLEM. But first – what is risk?

risky financial position

 

Risk We All Face Every Day: Whether You know it or not.

We as human beings on this earth deal with risk every minute of every day. But we have learned to live with certain amounts of risk. Let me show you.

riskEvery time you drive in a car you risk the possibility of an accident (life-threatening or otherwise). For example it is estimated that the chance of you dying in a car crash is 1 in 10000 or a 0.01% chance. Most people would consider this low risk. We still get in a our cars and drive don’t we? Well, we used to – after reading this maybe some of us will walk everywhere instead.

The chance of you dying from being hit by a car while walking is 1 in 47000 or a 0.002% chance. So obviously there is much less risk of death by car while you are walking vs driving. Which makes sense, and I think most of us intuitively know this. It’s more dangerous to travel fast (in cars) than slow (walking). We are conditioned to accept the amount of risk required to operate a car every day. And we do it without thinking about it – at least consciously.

When it comes to other dangerous activities – some of us refuse to participate – usually based on the risk involved. For example, my dear wife refuses to ever go skydiving. “It’s too risky.” Even if the odds are in her favor. Which they are. The chance of dying while skydiving is 0.0007%. Compare that to the risk of dying in a car crash.

0.01% (car crash) vs 0.0007% (skydiving)

So you see, you are 14 times MORE likely to die in a car crash than skydiving.

So in some cases our perceived risk doesn't match reality. Click To Tweet

But I think it’s safe to say that most of us would rather drive than skydive.

Financial Risk Related to Common Transactions

In financial terms everything we do carries risk in some form or another. But are we thinking about it in proper terms of risk? What is our perception of the financial risk of certain forms of debt or other money transactions?

Let’s first define risk in financial terms.

Financial risk is the chance that the worst will happen multiplied by the magnitude of the loss.

For example, let’s say you have an income of $60,000 per year. And you decide you want to buy a house for 1.2 million dollars (Probably not a smart idea). That would be a mortgage (with a 20% down payment) of 1 million dollars. The payment (not including taxes and insurance) would be $4774/month! That’s 57,288/year!! No bank would ever agree to this – you would certainly never be able to make the payments. If you could get a loan, this would be the maximum risk for you. You are certain to default and lose your house.

House in winter

On the flip side, with the same $60k income, let’s assume you found another house. This one is $120k. That would be a mortgage (with a 20% down payment) of $100k. This monthly payment would be only $477/month. That’s $5724/year. This scenario carries much less risk, and a bank would be more than willing to loan you the money for this house.

There are many other debts that carry different levels of risk as well.

Risk Example Table

In the table below, I’ve compiled some common money transactions. I calculated a risk level score based on current default rates for the various transactions. The default rates commonly published were used as the probabilities of default for the various forms of debt. I think this is a reasonable assumption, because these default rates are based on historical data. Higher risk level = bad or more risky.

Risk Example Table

EventAmount of Loan/Acct
Probability (%)Risk LevelNotes
Mortgage150,00013.7630 year fixed rate - generally low interest rate
Home Equity (2nd Mortgage)20,00045.6615 year terms - borrow against the equity in your house - adjustable rate
Student Loan40,0001224.0020 year payoff - reasonable interest rate - high risk due to default rates
Car Loan20,00045.665 year term - Cars always depreciate
Credit Card Debt15,00056.12min payment is 2% of amount borrowed - usually high interest rate
Payday Loan2,0004620.572 week term - very high APR
Lottery Tickets101003.16Lower risk - but basically throw away money

Notice that the default rate of the loan category greatly affects the risk. Student loans are high risk because of the uncertainty of income after graduation as compared to the amount of most loans. Read more about student loans here.

Figure Out Your Own Risk Position

If you would like to calculate your own risk score for your specific situation, I’ve created a spreadsheet similar to the one above. It’s available for download for free. It also includes fields to input your annual income and savings – as this will impact your overall risk. The higher your income relative to your debt – the lower your risk will be.

You will also be able to change different loan amounts and see how they affect your aggregate risk score. For instance: if you pay off your credit card debt – your risk level score will decrease while your aggregate risk score increases.

Just as an aside, I don’t think this risk score relates to anything other than this spreadsheet, but it does give you an idea how risky certain loans are compared to others. Plus, if you like numbers and spreadsheets – like me – it’s fun to play around with sheets like this. Have fun with it, and try to reduce your financial risk in each category.

Lastly, if you enjoyed this post, please do me a favor and share this post using the social media links below.

-Chris

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