Got Debt? If you are like most Americans or a majority of my clients, you do. Debt, in general, doesn’t have to be a bad thing, though those who use it without a plan tend to find themselves using it improperly. We’ll review the power of properly using debt, the downsides of debt, why being debt free isn’t all it’s cracked up to be, and how to manage debt efficiently.
Why Use Debt
Debt is a tool that when properly used can be leveraged to both maximize your lifestyle and reach your long-term goals faster. Just think about some of the things that may be out of reach to a normal young professional or family with having access to debt.
Education is ridiculously expensive, but unfortunately, the reality is for most professions you need some type of formal education in order to create opportunities. What 18 year old has $10,000- $20,000 a year to obtain this education? I will say that I don’t feel that everyone needs to go to college, but
There are two aspects of this from my experience.
- Travel for employment: Initially entering the workforce, it is nice to have more control over your commute than what public transportation provides. Maybe a $500 vehicle might workout, but it is more likely that you will be spending a few thousand dollars just to have a decently reliable vehicle to earn your living.
- Responsibility: I need to write a whole strategy guide just on this. In short, when my wife and I were expecting our first child, we felt that we should upgrade my Prius to an SUV for winter commutes and overall safety.
Neither of the above are considered “needs”, but are pretty common lifestyle decisions that provide peace of mind and increased control.
Not trying to tackle the rent vs. buy conversation here, but if you are set on homeownership, it is nearly impossible to do without absorbing a mortgage. According to Zillow, the average home price in Fort Collins, CO is $392,000! How long would it take you to save that much? Don’t forget to factor in inflation, which means that $392,000 will increase in price every year while you are trying to save for it.
All of the above-referenced assets are also on the lower end of the interest rate spectrum, which means that these higher value items have some of the lowest cost to access (lowest cost being very relative). If you take a full 30-years to pay off a mortgage, even that low-interest rate will have you paying more than double what the original loan value was (inflation and home appreciation help offset what sounds like a ridiculous cost).
The Downsides of Debt
Not everything that people use debt for is to access an asset though. Instead, things like credit cards, personal loans, and debt consolidation loans are used to fund the purchase of toys, jewelry, weddings, dining out, furniture, vacations, and
The most noticeable downside to debt is the cost of borrowing. Also, known as financing cost or interest cost. Most people like to ignore this aspect when thinking about charging their credit cards or applying for a new loan. Instead, they think about “can I make this payment each month?”. It is important to make your payments, but the cost of the decision is SO much more important. Like ridiculously more important. If you have been carrying a credit card balance for quite some time, go and access your end of year statements for each year and add up the lines that say total interest paid. That same information can be found on your auto loans and mortgages, but at least with those loans, you remember what the interest is being charged on. Do you remember everything you are paying interest on for your credit card?
They All Add Up
So let’s say you can afford the monthly payments. Those payments begin to stack up. Think about your glass as being your total monthly income. Every new monthly commitment starts to eat up your disposable income. It’s very easy with debt alone to be near 50% of your income being subtracted each and every month. The more you fill up your glass with past purchasing decisions the less flexibility you will have to take advantage of opportunities and achieving more meaningful goals.
Does it ever feel like you are not getting ahead? There are two culprits that I see all of the time that causes you to be treading water instead of making progress:
Credit cards are a revolving credit line, which means as long as you make the minimum payment, you can have the credit card forever. Many people abuse credit cards and use the “revolving” part of the description too literally!
Example: If you owe $2,000 on a credit card and even though the minimum payment is $50, you pay an additional $150 because you want to pay it off faster. That sounds like an awesome plan, right? Well, most people do this and feel like they are making progress, but then charge another $200 during that same time period. Initially, you would think their charges negate their payments equally, but this is a credit card and interest isn’t cheap. With a 22% interest rate, the interest charged to the credit card would be $37! So they are actually behind $37 when they thought they were getting ahead.
Payoff and Replace
Another common behavior I see is when people feel like that just because they paid off a loan that they should replace that monthly payment with another loan. The thinking is “I can afford it”, which is a dangerous justification and often a flawed one. Many people fail to factor in everything they probably should be doing (emergency savings, proper life insurance, retirement savings, etc.) before they come to the conclusion that they can really afford something or not. This occurs most commonly with vehicles. Similar to the credit card example, people often find themselves in a worse place financially because the new purchase tends to be a higher cost than the previous vehicle. How does this happen? Over the years they paid down their previous vehicle they received pay raises and inflation may have increased the cost of the vehicle itself.
Financial stress (44%) is greater for Americans than work (18%) and relationships (25%) combined! Those statistics speak for themselves, but I am sure you might be thinking to yourself, that is only people in poverty. Are you in poverty? Do you sometimes get stressed by your financial decisions and planning? A majority of my clients earn six figures and they are just as stressed about their financial situation as lower income earners.
You may be wondering, “I need help, but Why Level Up Financial Planning?”
Debt Free the Way to Be?
It is not as clean cut as you would expect it to be when it comes to being debt free.
Benefits of Being Debt Free
There is a pretty significant emotional value in not owing anything to anyone. You may not be financially independent but you will have a little bit more freedom than someone who is maxed out with debt. Be aware though that emotional decisions are not always the best if it is blocking your judgement from more beneficial maneuvers.
If you are not borrowing money, then you are not paying interest. How much you pay for your vehicles and various consumer purchases are the exact cost you pay. When you finance these purchases your initial cost becomes inflated the higher the interest rate and the longer you borrow these funds.
When you don’t have a pile of debt payments to pay each month, you have more control over where your money goes every month. If you properly utilize this control, you can also speed up the time it takes you to become financially independent or make more fulfilling career decisions.
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Negatives of Being Debt Free
I have seen many times where people whom are debt free felt like they were totally rocking their financial planning only to realize that they are still behind in many aspects. Where did they fall short? Usually one or multiple of the following:
Still Living Paycheck to Paycheck
I have been on record as calling most Americans ninjas at living paycheck to paycheck. The truth is that most people live it up as much as they can. If they earn less they may avoid going into debt, but don’t make progress. Even as their pay increases, they consistently find ways to spend it from lifestyle creep.
No Savings or Retirement Savings
Having no debt gives some a false sense of safety from needing an emergency savings or retirement savings. If you manage to save a high percentage of income and even start to apply it towards long-term investments, then you will significantly increase the speed at which you may become financially independent.
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Still Had High Rent Payments
Again, I don’t want to paint the picture that owning is better than renting because that is a personal preference, but if you have expensive taste in your rental you are at the mercy of rising rents that may take a significant portion of your income every year. Alternatively, if you consistently find lower rent options, then that could be a huge positive.
No Life Insurance
If you have anyone else that depends on your income, then there is a high probability you should have decent life insurance coverage. You may not need as much as someone that carries significant debt loads, but you still have to replace likely years of income that could evaporate if tragedy were to strike.
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Have a Debt Management Game Plan
- Avoid basing purchasing decisions off of affordability.
Without a complete strategy guide, you may not fully understand what you can and cannot afford in the grand scheme of things. Also, financial institutions are very generous with how much they are willing to tell you that you can afford. The more they lend, the more they get paid and they do not care if you are making progress.
- Never pay double-digit interest rates. These debts are associated with consumer purchases and are not tied to an asset. Carrying double-digit balances will eat away thousands and thousands of dollars over your lifetime that I am sure you would prefer to use towards other more important goals.
- Remove emotion when paying down debt. This is one of the emotional traps we create for ourselves. Student loans are a pain in the butt and you just want to get rid of them? What if you have credit card debt that has twice the interest? The credit card is a dramatically bigger problem than your student loans, but many times people attack some of the more friendly debt and avoid the real problem areas.
- Determine your strategy. Attacking the highest interest rate or the lowest balance? It helps to have a strategy so that you don’t get caught in the emotional trap mentioned above. Paying the highest interest rate first will save you the most money while paying off the lowest balances first frees up cash flow and gives you a positive emotional boost.
- Understand how much extra you can pay. You have your minimum required payments, but maybe you want to pay off your debt faster. Don’t randomly throw your money at your debt not knowing if you are over-committing. When that happens you create frustration because you are not making the progress you expect. You are overextending yourself and re-adding debt in the form of credit card debt, which may be more expensive than the debt you are paying off.
- Stay focussed. If you are overwhelmed with all of the line items of debt that you have, you may feel the urge to “spray and pray”. That is when you feel like you need to make extra payments on everything. That strategy is really inefficient and will make it feel chaotic. Being focussed allows you to have maximum control and confidence with your approach to paying down debt.
- Refinance to lower rates when opportunities exist.
- There are a few instances when refinancing to lower rates doesn’t make sense: if you lose certain benefits or the fees reduce or eliminate the expense of refinancing.
- Don’t forget the rewards. If you have a great handle on your spending habits, you may benefit from the value of reward credit cards. There are sign up bonuses and ongoing rewards that you can have without ever paying a cent in interest if you pay off your balance every month. That’s free money!
Debt may be unavoidable, but that doesn’t mean that it has to weigh you down. Efficiently managing debt may allow you to obtain a higher paying job, have a higher quality of life, and grow your wealth faster. The key is having a game plan and staying focused so that you avoid some of the common downsides of debt.
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