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Below Your Means Basics: Understanding Your Debt

Before we get started, if you are months away from foreclosure or other serious financial consequences, this is not the article for you. We do not cover issues like bankruptcy, credit repair, or debt settlement agencies. Consider consulting the assistance of your financial adviser and/or attorney. Our favorite online legal resource is Nolo.com.  Nolo’s Bankruptcy Center has plenty of good, free information and they also offer a variety of for-fee products to help those with serious credit and debt problems.

The biggest problem with amassing debt is that you are giving up flexibility in your future for flexibility today.  You are agreeing that in the future you will be willing and able to have a certain amount of money.  But none of us can predict the future.  We don’t know what misfortune will befall us, what opportunities will come our way, and what our personal goals will be.  You can read more about our thoughts on debt in our first Back to Basics article.

To get out of debt, and to understand how to use debt in the future, you need to stop thinking about your debt in Income terms and start thinking about it in Net Worth terms.  Meaning, stop thinking about how much debt you can afford to carry (payments), and start thinking about your total net worth, what direction it is heading in and the impact of debt on your net worth.  When you carry debt, you are simply spending money on the privilege of borrowing — you’re paying interest, potentially fees and the money isn’t helping you.  People borrow money all the time without considering the interest payments because the monthly payment seems affordable.  But if I gave you $100 tomorrow, and told you that you had to light a $5 bill on fire every Friday until you paid me back my $100, you’d stop and think about it.

The Debt Payment

Many people when budgeting plan for an $x credit card payment; for argument’s sake let’s use $100/month on a $5,000 debt.  While this approach is practical when you’re dividing up your monthly income, it doesn’t tell you whether or not you’re paying off your debt quickly enough.

Every debt has two key components – the principal (the amount you borrowed — on a credit card this is often the ‘balance’) and the interest (the fee you are paying to the lender to borrow the money).  When you make a debt payment, you typically pay the interest first, and the principal second.  Your payment needs to be high enough to take a good chunk out of the principal of the debt, or else you’ll simply be paying interest month after month.  The Federal Reserve Credit Card Repayment Calculator is a handy resource for approximating the time and money credit card debt will cost you.

Looking at the $100/month payment on a $5,000 debt using an APR (interest rate) of 16%:

  • If you saved up the money ahead of time in $100/month installments, it would take you 4 years and 2 months to come up with the $5,000.
  • If you make the $5,000 purchase and pay $100/month, it will take you 27 years to pay back the debt, and you’ll spend an additional $8,659 in interest.

Why so much interest?  Because your $100/month payment is barely making a dent in the principal of the loan, so the interest keeps piling up and piling up.

If you make larger payments you’ll cut into the principal faster.  Take a look at these two scenarios of paying off the same $5,000 debt at a 16% APR:

  • By paying an extra $42/month, for a total payment of $142, you can cut the time down from 27 years to 4 years and cut the interest from $8,659 to $1,802.  That’s 23 years less, and it reduces the interest by $6,857.
  • By paying an extra $100/month, for a total payment of $200, you can cut the time down from 27 years to about 3 years and the interest will drop to $1,123.

Federal Reserve Credit Calc Site

 

When Debt Helps and When it Hurts

About Credit Cards

Short term debt — debt you carry less than 12 months — is mostly useful to manage cash flow.  For example, you may be paid your salary every 2 weeks but most of your bills come on a monthly schedule.  So, you use your first paycheck to pay off all your monthly bills (and savings goals), and your second paycheck pays off your credit card balance – in full.  Note that if you have saved even 2 weeks of your pay, there really isn’t a need to use your credit card like this.

Another good example of a short term cash flow crunch comes from different types of insurance and fees that are due quarterly or annually.  These bills may push a given month’s expenses over that month’s income.  A credit card will help, but again only if you’ve budgeted for the expense and your income pays off the credit card in a few months, including the interest.  Otherwise, you’re accumulating debt.

Sometimes emergencies exceed the savings we have in our emergency fund, and in that case, carrying some debt while you adjust your budget and quickly pay it off can be a lifesaver.

Outside of these examples, in most cases credit cards are really just a convenience that means you don’t have to carry around cash, and you only have to make one payment out of your bank account per month to cover your purchases.

Long Term Loans on Short Term Assets

Another place people often exceed their means is getting long term loans for a short term asset.  A short-term asset is anything that is not going to retain it’s value for long.

For example, car loans have recently gotten longer and longer, and it is possible to get a car loan that is 5, 6 or even 7 years long.  While this might make the monthly payments low enough to be within reach from an income perspective, it usually adds up to a lot of additional interest on the car.  Worse, the car will lose its value faster than you can pay down the loan.  That means that in two years you will owe, for example, $20,000 on a car that is only worth $15,000.  What do you think happens to you if the unexpected occurs?  Say, you car gets totaled in an accident, and you’re given $15,000 by your insurance company.  You will still owe the bank $5,000.  What happens when the car starts to need serious repairs in years 5, 6 and 7?  Or, say in 3 years you just don’t like the car any more.  It isn’t suited for your life.  If you try to sell the car, you’ll owe more on it than you can make.  You’re stuck.

Credit cards can be even more insidious though, especially when you use them to live beyond your means.  Let’s use a much more common example.  You routinely spend $200 more a month than you make, and you eat out a lot.  In fact, your entire $200 budget overage comes from eating out.  Over the course of just one year you will accumulate $2,200+ in credit card debt even if you’re making the monthly payment.  And it will only take 7 months for credit card interest to consume your entire dining out budget.  The chart below illustrates the example, but of course at month 7 it loses accuracy, since you can no longer afford to eat out OR make your monthly minimum payment.  At this point things start to spiral out of control.

Balance Charge Interest Minimum Payment New Balance
Jan - 200.00 - - 200.00
Feb 200.00 200.00 33.52 35.52 398.00
Mar 398.00 200.00 66.70 70.68 594.02
Apr 594.02 200.00 99.56 105.50 788.08
May 788.08 200.00 132.08 139.96 980.20
Jun 980.20 200.00 164.28 174.08 1,170.40
Jul 1,170.40 200.00 196.16 207.86 1,358.69
Aug 1,358.69 200.00 227.72 241.30 1,545.11
Sep 1,545.11 200.00 258.96 274.41 1,729.66
Oct 1,729.66 200.00 289.89 307.19 1,912.36
Nov 1,912.36 200.00 320.51 339.63 2,093.23
Dec 2,093.23 200.00 350.83 371.76 2,272.30

Using Debt Successfully

Before you begin you need figure out if you can trust yourself with debt. In the wrong hands, debt can be like alcohol to an alcoholic. Some people simply cannot control themselves, if you reflect upon it, and you fit into this camp you need to take a strategy of never using debt. Live a cash-only life; people do it all the time. However if you can trust yourself with debt and manage it, it can be a very effective tool to building wealth and happiness.

Also, in general we are going to strongly recommend that you steer clear of interest-only financing, balloon financing and other complicated debt instruments unless you fully understand what you are getting yourself into.  These debts, while designed to provide lower payments, are intended for people with a very good grasp on their finances and are able to predict with certainty and comfort that they will be able to refinance in the future, or make the balloon payment.  If you have to ask the opinion of anyone who isn’t (1) gifted when it comes to finance  (2) impeccably trustworthy and (3) completely unconnected to (will not benefit from) the transaction, then you probably shouldn’t be doing it.

Short Term and Mid Term Debt

First, provided that you budget for it (including the interest), short term debt can be a great way to get over a hurdle that seems insurmountable.  For example, say you have recently graduated from college.  You are working an hourly shift job to pay your bills while looking for work.  But, you don’t have a suit, and while you’ve started saving up for one, you get an opportunity to interview before you’ve saved up enough money to buy the suit you need for the interview.  Assuming you can’t borrow a suit from a similarly-sized friend, you could finance the suit on a credit card.  However, make sure you heed the following guidelines:

  • Figure out how much you are willing to spend before you make the decision to borrow the money.  Don’t let easy borrowing convince you to spend more than you should
  • Figure out how long it will take you to pay back the loan, and make sure that amount is much shorter than the useful life of the asset.  Paying back the suit in 6 months is OK, 3 is even better.
  • Adjust your budget to include the interest payments.  In this example, you are already saving up for a suit so you have a line in your budget for the principal payments.  BUT, this will change to include interest.  Don’t extend the time you are going to pay back if you can avoid it — just cut back on a few areas to include the interest payment.
  • Avoid making rationalizations about future earnings.  You may get the job, you may not.  If you get the job you can pay off the suit much faster than you expected, giving you more freedom in the future. If you don’t you aren’t stuck with a credit card payment you can’t afford.

Mid term debt is debt that you carry for 1 to 5 years.  A great example of this would be a car payment.  Car payments are another great way to get into a vehicle that will make a big change in your quality of life.  But again, beware the rationalization.  You don’t need to have a car payment all the time, and NOT having one is very freeing. There are many examples of millionaires driving modest cars, the big secret here is that the many got to be millionaires by focusing on their net worth and not how fancy their car is.  There are lots of tips out there for getting the best deal on a car, but consider these from a Net Worth perspective:

  • New cars depreciate much faster than slightly used cars.  Reliable used cars depreciate the slowest.  Buying a car that is a few years old can make sure you get the most value from the money you spent.
  • Financing a car for more than three or four years is gambling that you will want the car that long, and that it will run well that long.  Otherwise you are risking that the value of the car will drop below the amount that you owe.
  • A car is, at it’s heart, 4 wheels that get you where you are going.  Don’t fall into the trap of buying a car because ‘you deserve it’ or ‘you have to have it.’  Consider what you value.  A Lexus, Acura, or Infiniti luxury brand is certainly nice to ride in, and may be worth the money to you if you have it.  But going into a large loan to buy the car doesn’t make sense, especially when you consider that they are luxury versions of Toyotas, Hondas and Nissans.

Long Term Debt

Long term debt, debt that you carry for 5 year or more, should be reserved for performing or appreciating assets only.  What do we mean by ‘performing or appreciating assets’?  These are assets that either make money in and of themselves (like businesses) or have significant potential to increase in value.  Recent housing bubble aside, historically housing has been a pretty good performing and appreciating asset.  One, you can live in it while you’re paying off the mortgage, which might be better than paying rent.  Two, there is a good chance that when you go to sell the house you will get a significant amount of your money back. But there are lots of reasons why a house might not make sense.  As either the buyer or seller, you pay a lot of money in taxes, fees, commissions, etc. that aren’t included in the value of the house.  If you move frequently, these charges can add up.  And, if you can’t sell the house for more than you owe, you’re stuck.  Also, houses don’t always hold their value, as just about everybody now knows.

The subject of investing in a business or borrowing to finance other investments is beyond the scope of this article, but we will address it further in the coming months.

Financing vs. Savings

One other special case deals with taking advantage of free or very inexpensive financing.  Assume you have $4,000 in a interest bearing account that is earning 2%.  You have decided to buy new living room furniture that will cost you $4,000.  The furniture manufacturer is partnering with a credit card company offering interest-free financing for 6 months, which jumps to 22.9% if you don’t pay off the furniture by then.  The credit card company is counting on the fact that you’ll buy too much furniture because of the financing and wind up not paying it off.  You’ll owe them thousands of dollars in interest by the time you manage to pay off the furniture.  But, because you follow our ‘short term debt’ guidelines above, you don’t overbuy.  Taking advantage of the financing is a good idea – it means you can leave that $4,000 sitting in the account for 6 more months earning interest.  And if you adjust your budget, you may be able to pay off the furniture over that six months without having to touch your $4,000 at all.  But be careful – don’t use this as a way to rationalize buying $4,000 worth of furniture you can’t afford.  If you don’t have the money in 6 months, the high interest rate will turn your furniture purchase into a long term debt with lots of money disappearing into interest payments.

Emergencies

Of course, debt is also valuable to have at your disposal in case of emergencies.  But we’ll discuss that along side savings next time, as it is closely tied to the subject of emergency funds…

 

Thumbnail Photo: Blocks 1 by Crissy Alright

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1 Response to “Below Your Means Basics: Understanding Your Debt”


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