Saturday, August 16, 2008

What debt does to your lifestyle

Many people get into financial trouble because they live for the moment and fail to plan for the future.  One of the easiest ways to sabotage your own finances is accumulate too much debt.

While the use of debt to purchase a house, start a business, or in some cases make a major purchase such as a car can be smart, debt is always dangerous.  Debt used to finance a lifestyle - dining out, vacations, remodeling, or shopping - is especially dangerous.

Lets take a look at two young couples to see how debt can effect your lifestyle and financial well-being.

Both couples make a combined income of $70,000/ year.  However, they both handle that money very differently.

Couple A is not presently concerned about saving for retirement.  They eat our frequently, take great vacations, drive nice cars, and thoroughly enjoy life.  However, their salary does not quite cover all of their expenses.  They manage to rack up $5,000 of credit card debt every year.

Couple B likes nice things too, but also wants to plan for the future.  They save 10% of their income for retirement and give $3,000 to charities every year.  Couple B also makes sure that not to spend more than they have and does not accumulate credit card debt.

So for right now, couple A has $75,000 to support their lifestyle, where as couple B is choosing to make do with only $60,000.  However, lets see what things look like if both couples continue down this path.

After five years have gone by, Couple A is still spending and accumulating debt.  However, one of them gets a $5,000 raise, bringing their annual income up to $75,000.  They decide that it is finally time to start planning for retirement.  Taking stock of their situation they realize that they have nothing saved and have accumulated $25,000 in debt.  If they are paying 18% interest on their debt, that means that they need to pay $4,500 in interest payments every year.  They will need to pay even more to pay down the balance on their cards.  So, they decide to set aside $6,000 every year to pay down their debt and to begin saving 10% of their salary for retirement.  When you add all of this up, couple A has nothing saved and now despite a nice raise, has only $61,500 each year to spend.

Believe it or not, one of the members of Couple B gets a $5,000 raise after five years too!  They continue to give $3,000 to charities and to save 10% of their income for retirement.  This means that couple A now has $64,500 left to spend and assuming an 8% return on their investment, already has $44,000 put away for retirement.  If this $44,000 is given another 25 years to grow it will be worth $442,000 even if Couple A never adds another dime.

Here are the important points that I see in this illustration:
  • Taking on debt means spending future income today.  Doing so only sets you up for future disappointment.  While couple A probably had a lot of fun in those first five years, it will be a long time before they will be able to spend at that level again.  Even though they got a raise, they had to cut their spending by almost 20%.  Couple B meanwhile, will likely generally be able to steadily increase their spending as time goes by and their income level rises. 
  • Couple A had five years of better living than couple B did.  However, after only five years, Couple B has no debt, a substantial amount of money saved for the future, and a higher level of spending then couple A.  All this while still donating a significant amount of money to causes that matter to them.
  • Over those first five years, couple A did have more to spend and probably had a lot of fun.  However, couple A will never catch up to couple B.  There is now a $71,000 difference between the net worths of each couple.  Even once couple A pays off their debt, they will still have significantly less money saved for retirement.
  • The longer one lives above their means, the more damaging it is to their long term financial situation.
  • Even while saving for your future, it is often possible to give generously to causes that you care about. 

1 comment:

Anonymous said...

Where have you been all my life! Your column is amazing - filled with practical advice anyone can understand. You break down scary complex financial information and without being condescending make it understandable. Seeing a five year projection is very helpful.