Excessive use, or misuse, of debt is 1 of the top 5 reasons people go bankrupt. Bad debt can also be the harsh instrument by which your paycheck’s take-home, for example, goes from $1,200 to $500 (car payment, credit card balance, monthly payment on furniture, …). The #1 way to fix your problems with bad debt is to NEVER, under any circumstances, let it into your life.
For some of us, unfortunately, bad debt is already in and roaming around our homes, apartments, and vehicles. What we’ll do here then, is this:
-Review how to distinguish bad debt from good (yes, there is such a thing),
-Evaluate ways to eliminate any bad debt already accumulated, and
-Make certain we have a plan in place to keep bad debt out of our lives for good.
This is financial pillar #4 for us millennials.
Please click on the following links to view the introduction post (We had a huge financial crisis, now what?), or preceding posts in this series. Thanks for reading! I’d love to hear your thoughts in the comments section.
What separates bad debt from good?
“Wait a minute… you’re saying there is such a thing as good debt?” Yes, I am.
What’s more, some financial experts will even tell you to make only the minimum payments on certain loans.
Let’s take, for example, a home mortgage. To keep the math simple, we’ll say you capitalized on the low interest rates in 2012 and took out a $100,000 home loan with a fair 4.00% interest rate. If we take this loan in a sterile environment and eliminate tax payments, homeowners insurance, PMI (Private Mortgage Insurance), and any HOA fees, we can then evaluate your home purchase as the investment it can be.
I already hear you out there. “Woah! We’ll just overlook taxes, insurance, and other fees? That’s not reality, bro…”
First of all, thanks for calling me “bro.”
Secondly, you should be paying renters insurance in the event you are renting and although the figure would most assuredly be different compared with homeowners insurance, there is still a fee to be paid. PMI would not apply if you are able to pay at least 20% of the home’s price up front (that’s $20k in our example). HOA fees can be seen in the inflated rent payment you pay each month, and are alright with doing because of the gym and pool you use 5 times annually… combined.
Not to mention 100% of your rent payment is gone every month. You pay, the landlord collects, digits shift, and the deal is done. With a mortgage, at least some percentage of your monthly payment goes toward your principle. Which is to say that you are investing your money, and that money can be recouped when your home is sold. The less you owe on your mortgage, the more of the home you own and the bank doesn’t, and the more you are paid at the time of sale. When your rental agreement is up you’ll be lucky to get your security deposit back.
With that out of the way, let’s get back to our example.
$100k over 30 years at 4.00% interest. Your monthly payment would be $477.24 – wouldn’t that be sweet… Using a mortgage calculator, I’ve calculated that your total interest paid would be $71,867 meaning your total sum paid is $171,867.
One huge point to remember is that this sum is paid over the course of 30 years and that your monthly payment of $477.42 in 2012 is not the same as that same sum in 2042. Two factors are at work here. Inflation over the course of time.
Inflation (definition) – a general increase in prices and fall in the purchasing value of money.
Inflation varies throughout time but has acted at an average rate of 2.5-3.5% in the U.S. over the last 30 years. This is a great advantage of a mortgage. When you take out your loan, you lock in the value of your $100k at the 2012 inflation rate. When your loan has matured, 30 years later, inflation has influenced prices and the overall value of money but your payments and mortgage do not adjust in accordance with that inflation rate. Your payments stay at $477.42 each month even though that $477.42 is technically worth less and less each month, as compared with the U.S. economy.
Over time, and while inflation is acting on overall economic conditions, home values will tend to rise. Of course this is location dependent and will vary from place to place but as the savvy investor you are, research was done up front and you picked a great location to buy so that home values in your town will hopefully rise – pending major shift or natural disaster.
Looking at the national average over the last 30 years, housing prices have elevated about 260%. That’s about 8.6% annually, keeping in mind that this time period includes one of the most severe economic crashes in our nation’s history.
Rounding these numbers up:
If these averages hold (let’s assume they’re close, for the sake of argument), our $100k home from 2012 should be worth about $260k in 2042. A $160,000 increase in value!! That makes the $71,867 in total interest seem miniscule. On top of that, by the time your mortgage is paid off, your $477.42 monthly payment comprises a significantly smaller portion of your paycheck. As inflation has acted on the economy over the last 30 years, hopefully your earnings have risen to reflect that change (or something close to it). Add that to the fact that 2042 dollars are less valuable than 2012 dollars and time has really benefited you here.
Home mortgages also provide you with a tax credit at the end of the year in the form of the homeowners credit. Alright, enough about mortgages. I would also classify SOME business and student loans as good debt as well.
For student loans: if you are making an investment into yourself that will afford you the opportunity to earn more over time, this will ultimately be a net positive. Business loans can mean the same thing. If your earning power is elevated by opening a business, the interest and payments you make for using someone else’s money are more than worth it. Of course there are examples with both of these loans that can be disastrous. Do your research, make the right choice, and commit to yourself.
What are some forms of bad debt?
Credit cards, payday loans, cash advances, new car loans and leases, and any other reason you buy something via financing.
Remember the 4-ish percent we were discussing for home mortgage loans? The current average interest rate for credit cards is 15.07% – and that’s if you have good credit. The bad credit rate: 22.73%.
As an example, if you buy a $1,000 couch using a store credit card via payments for 60 months (5 years), you can expect to pay $429.60 in interest over the 5 year loan (this assumes the lower 15.07% rate). Sure, the $23.83 monthly payment doesn’t seem bad, but how about paying $1,429.60 for a $1k couch?? That sounds terrible to me.
But Mike, I already made the mistake and took on the debt… What can I do to fix that?
Prioritize and execute – borrowed from Jocko Willink (Jocko Podcast) who probably borrowed it from someone else.
Now that you’ve identified the problem(s), it’s time to get to work. The means by which someone eliminates bad debt can be very personal. Some prioritize based on interest rate while others focus on total balance. The pace can also vary. Blitzkrieg versus leisure, or perhaps somewhere in the middle.
Whatever the pathway, the point is to get rid of this bad debt. But no matter how bad you want to eliminate this burden, chances are that your spending and/or earning behaviors will have to adjust.
To do the same thing repeatedly expecting a different result leads to more debt, less self confidence, and potentially a self-pitying spending spree – modified from Einstein. Point being: you will have to leave the comfort zone, probably try something new, and turn want into act.
For you that may be a second job, cutting a vacation, or it could be as simple as Sitting down and making a budget. In any case, you have options.
I recommend two great resources to get started here. The first is a shameless plug: The spending freeze – jump start your budget. The second is from a widely respect author whose methods have led to repeated success stories from many different people with similar circumstances: The total money makeover by Dave Ramsey.
Once you’ve identified your specific path, the only thing left to do is get started. Operation debt elimination is now underway.
Now, let’s keep bad debt out of our lives for good
If your life is following along with this post, either 1 or both of these things are true:
1) You’ve formed great spending, saving, and earning habits that helped get you out of debt, or
2) You were never in debt meaning you were either taught well, learned good practices yourself, or… You are lucky.
From this point on though, I contend that good planning coupled with determination and hard work, will significantly minimize (if not eliminate) your need to use bad debt.
The good planning consists of making a budget, identifying your savings goals, prioritizing what you want to spend money on, determining your needed income, etc. Exercising determination and hard work simply implies you stick with your good plan.
That means you no longer believe in impulsive purchases. I’m not saying you can no longer have nice things. I am saying the act of purchasing those nice things will be researched, contemplated, and weighed for importance. Using this strategy helps to eliminate the need to use bad debt. Meaning – without blindly spending (either large purchases or small purchases ‘here and there’) coupled with appropriately saving, you insulate your finances from disaster lurking in the shadows.
“But Mike, what if I need to act quickly on a purchase?”
First of all, Christmas is not a surprise item in the budget line. A little foresight could go a long way if that is the case. Secondly, If that item is so vital that it is completely necessary, save up and pay cash if possible. If you don’t have time to save up, then find a way (via the budget) to eliminate a normal expenditure (or 2) for the month so that you can pay the most cash possible. A little sacrifice now will be much sweeter later when you’re not paying 20% interest – or, $120 for a $100 item…
“But Mike, my furnace is dead and winter is here…?”
As the responsible individual who is in control of your own finances, you were proactive when you established an emergency fund for home repairs just like this one. Transfer the cash, fix the furnace, and resume disciplined savings.
Once you’ve identified the difference between good and bad debt, eliminated any bad debt in your life, and put systems in place to make sure you never need bad debt again, you’re now able to take control of your life in ways previously unimagined. While the journey toward financial freedom tastes like ground chuck, I understand the destination is more like filet mignon.
Thanks for reading!
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