This is the fourth part of our new series about how to get your financial life in order by focusing first on the four most important parts of your financial life: saving, investing, protecting your income, and managing debt. We’ve discussed saving in detail in parts 2 and 3. Today, we’re going to delve into the main reason most people can’t save more money – DEBT.
As I mentioned in the previous article, it’s critically important to your financial future that you can save for future emergencies or short-term goals (and I even shared a few strategies to make sure your savings is actually growing, and not just sitting in a bank earning next to nothing).
If you remember, the reason we need to save, especially for emergencies, is because when those unexpected things happen in life, we need a source of money to cover them. Sadly, for most American families, their “emergency money” is a credit card. When things get really bad, they have to resort to things like pawn shops and payday loans, which are always prominent parts of lower-income neighborhoods.
A quick aside: one other thing I’ve noticed, working as an advisor in very impoverished parts of south Texas, is the high number of credit repair agencies (most of them worthless) that prey on these same unfortunate souls. Someone, somewhere convinced poorer communities that the most important thing they can do financially is getting a better credit score.
I promise to write a lengthy article about credit ratings, how they’re calculated, what they mean, and what scores you should actually try to reach at different income levels. Be sure to subscribe for updates when we’ve got something new here on the site, but for now, suffice it to say that unless something is materially inaccurate on your credit report, these companies aren’t going to be able to improve your score. Save your money.
So let’s explore the world of debt a little.
The world runs on debt, sadly.
Don’t feel bad if you’re in debt. Almost no one is completely debt-free, and there are times when incurring a debt instead of using a huge sum of your savings might actually make financial sense.
Every nation on earth is in debt (our country has over $22 trillion of it). Every state is in debt. Every city is in debt. Every school district, hospital, airport, road system, corporation, airline, automaker, and nearly every family carries at least some form of debt.
Used properly, debt isn’t necessarily a bad thing. For Rich Guys, governments and companies, it provides what’s called in the financial world leverage. It allows you to utilize more money than you personally have, to free up money for other immediate needs. It allows you to start or expand a business; build another factory, hire additional salespeople, and other useful, productive purposes.
Used wisely, debt can be smart for Average Guys, also. It allows you to purchase significant things that you don’t have the funds for right now. Again, in some instances, this makes sense. A 30-year mortgage allows a family to buy a home they’ll eventually own (and that keeps appreciating in value). Prudent student debt allows you to earn a degree, which increases your earning potential for the rest of your working life.
The problem comes when we’re going into debt for things we don’t actually need and that depreciate over time, instead of things that provide increasing value.
So here’s Rule #1 about debt: it’s only “good debt” if what you buy with it will appreciate in value for you later.
A house or a college education might be considered a “good” form of debt, as prohibitive as their repayments may be. But putting a TV or a refrigerator or (heaven forbid) clothing or gas or groceries, or any other items of minor value and that depreciate over time, is a horrible reason to go into debt.
Unfortunately, that kind of valueless debt – often called consumer debt – is an epidemic in the Western world. In America, consumer debt topped out at over $4 trillion at the end of 2018, an all-time high. (That’s 4,000,000,000,000 dollars – 4 million million dollars.) There is almost $12,000 of consumer debt for every man, woman and child in America.
Types of indebtedness for Average Guys
I’ll skip describing the types of debt governments and corporations undertake (usually called a Bond or a Note). This series is for Average Guys wanting to become Rich Guys, so we’ll give you a quick review of the different kinds of debt an Average Guy will fall prey to.
A secured debt is a debt that has something of value tied to it (called collateral), that the lender can use to recover the money they lent you. These are generally your big debts in life: your home mortgage, your car loan, and your student loans.
Because the lender has something of value they can take away from you if you stop paying the loan, and thereby recoup their money by selling that item (a house, a car), their risk is generally lower than other kinds of debt. If their risk is lower, the interest rate they will charge you is lower.
(Student loans aren’t actually collateralized with something tangible, but because the government now backs them, they’ve made them nearly impossible to get rid of or walk away from, even in bankruptcy. You have to pay them off. So for this example, I’m calling them a secured debt because their interest rate is usually low and they act more like a secured debt now than in years past.)
Basically, every other form of debt other than what I mentioned above is called Unsecured Debt. Unsecured debt is literally borrowing on your word to pay it back. The term “unsecured debt” covers things like credit cards, personal loans, lines of credit, etc.
The lender has nothing of collateral to back up their risk on the loan, so your ability to repay, and your prior history with debt, comes into play significantly in determining how much you’ll pay in interest for this debt. It is unsecured debt that is most greatly affected by a bad credit score, which is perfectly logical when you consider the lender’s risk.
You can also classify debt based on how it’s lent and how it’s paid back.
An installment loan is a debt that starts with a full amount borrowed, and you pay it off with a set payment amount for a specitic amount of time. Eventually, the debt is paid off and the loan is closed. You can’t partially pay down an installment loan and then rack up more debt on it. Once it’s paid off, it’s terminated.
Auto loans, student loans, and mortgages are always installment debt, but payday loans and even sketchy loan shark-type loans are brief installment-type transactions. Even when you borrow from your 401k, you pay in installments until the debt is cleared.
A revolving loan (or revolving line of credit) is a balance that is offered to you to use at will, over and over, if there’s a balance available to borrow. These are your credit cards, home equity lines of credit, overdraft protection at the bank, etc.
Because the revolving loans have a greater opportunity for misuse (you could rack up more debt than you can afford, up to the limit the lender set), and then walk away without providing any collateral, the risk for the lender is highest with kind of debt. As a result, the interest rates you’ll pay are the highest of any other kind of debt.
Repayments are also sporadic with revolving debt. Because the balance you owe can change each month, the lender will take your balance on a certain day each month, apply their interest to that balance, and then require a minimum payment (usually just enough to cover that month’s interest, but sometimes even less than that).
It is the easy access to more money, the typically very high-interest rate, and the very low minimum payment, that get so many people into trouble with revolving debt. Credit cards make buying things on impulse really easy and, at first glance, very affordable. It’s only when you’ve been paying on your credit card for a decade and not seeing the balance go down that the really nasty aspects of revolving debt finally show up.
Sadly, revolving debt is also the most commonly used kind of debt, and is most often used for valueless, depreciating, often frivolous purchases.
Ask yourself: how smart is it to borrow money at the highest possible interest rates, and then spend it on the lowest value items?
Rich guys never do that.
I’m not saying Rich Guys don’t go into debt. They do, but not to buy a new TV or a couch. They take on debt to expand their earning potential or to acquire an asset that is going to appreciate over time.
No Rich Guy would ever use debt to purchase essentially worthless “stuff” to fill up their houses or impress their friends. And yet, Average Guys do this exact thing all the time, just to impress other Average Guys with a phony show of status.
Get your head right about debt
Next week, we’ll give you a workable plan to begin to manage and ultimately eliminate your debt. It’ll take work, commitment, and more self-discipline than most Average Guys have. Thankfully, discipline is like a muscle that you can exercise and strengthen.
For now, as I wrap up this week’s course, I want you to consider how you view debt and how serious you are committed to changing the way you use it.
Commit to yourself the following two basic statements about debt:
- Debt should only be used for leverage: expand my earning potential or to acquire an appreciating asset.
- I will not go a single cent further into debt for something that isn’t leverage.
And finally, here’s some homework for you before next week:
- Gather all of your most recent statements from every debt you owe. You need a balance due, minimum payment and interest rate for each one.
- Determine how much extra money each month (above and beyond your minimum payments) that you will commit to paying off your debts.
I welcome your questions and comments as we continue this series!