Saturday, September 6, 2008

Be Your own financial planner part 3 - Debt can ruin your financial well-being

In an ideal world you would never need debt because you would always have enough money.  Our world is far from ideal.

I don't believe that there is such a thing as good debt.  However, there is a huge difference between very bad debt and less bad debt.  Managing your finances well might include taking on less bad debt such mortgages, student loans, and loans to start a business.  These types of debt tend to be less bad because:
  • the purpose of the debt is to leave you with an appreciating asset (house), valuable skills, or an increased income
  • they tend to have relatively lower interest rates
  • they often include tax advantages further lowering their cost
Credit card debt or any other debt that involves spending money that you don't have for things and experiences that you can't afford is very bad debt and will destroy your ability to manage your money well.

Imagine if you walked into a store and picked out a sweater to purchase.  As you picked it up, you notice a sale sticker on the tag - it reads: Today only, pay 70% more than the lowest marked price!  Would you buy the sweater?  Of course not.

However, whenever someone racks up charges on their credit card that they cannot pay off in full, this is the deal that they agree to.  Credit cards typically require a minimum payment of 4% of your balance every month.  This means that if you have a $10,000 balance, your minimum payment will be $400/month.  If your credit card charges you a 20% interest rate and you make only minimum payments, then it will take you almost 16 years to pay off your debt and it will cost you over $17,000 in total payments.  This is very bad debt.

America has a problem with credit cards.  Almost half of all households do not pay off their credit card balances every month.  That means that almost half of all households are spending beyond their means and likely failing to invest for the future.  Of households that do carry credit card debt, the average amount is $2,300.

If you have credit card debt, or other types of very bad debt, you need to pay it off as soon as you can.  If you only have one account, you should pay whatever you can above and beyond the minimum payment until your debt is gone.

If you have more than one account with very bad debt, you should make the minimum payment to all of your accounts.  You should also pay whatever extra amount above the minimum that you can afford to the account with the highest interest rate.

If you have credit card debt you should also seek to minimize the interest rate that you pay.  There are two ways to do this:
  1. Call your credit card company and ask for a lower rate.  It won't always work, but it is worth a shot.
  2. If you still have good credit and are getting credit card offers, see if you can find a way to transfer you debt to a card that offers no interest or low interest.  (If you do this be sure to carefully consider any fees that might be charged for balance transfers.)
Once you have taken care of your life insurance needs and have set aside some cash for emergencies, knocking off any very bad debt that you have is the fourth step in your financial plan.

5 comments:

Anonymous said...

How do you feel about getting a loan for a new car?

My family recently had to purchase an 8 seat SUV and we did not have enough cash to purchase it.

We were hoping that we will be able to keep the car for 10+ years, making it worth buying new.

Anonymous said...

I like the idea of thinking about the actual cost of purchasing an item if you are using a credit card! It certainly will make me think very hard about buying it now or waiting until I can pay "in cash".

RDS said...

Anon - thanks for your question.

I have mixed feelings about auto loans. Like many aspects of financial planning, auto loans by themselves are neither good nor bad, but can be used responsibly or irresponsibly.

They have a number of good qualities:
- Cars are both expensive and (outside of major cities) absolutely essential. Without loans, many people would simply not be able to buy a car.
- Unexpected job changes or family size changes might require the purchase of a new car on short notice. A loan can make this possible.
- In today's economic climate car loans can be had at relatively low interest rates.

However, car loans have their downsides:
- Taking out a car loan means spending your future income on an asset that will rapidly lose value.
- Auto loans enable people to purchase more expansive cars than they can responsibly afford to.

I believe that spending too much on vehicles is one of the most common major financial blunders made by American families. However, the root of this problem is a poor purchasing decision. The auto loan is merely the enabler. Car loans make sense in some circumstances, can be used responsibly, and can be an important part of your financial plan.

Your plan to purchase a vehicle that fits your needs and keep it for a long time sounds like a good financial decision.

tuuli said...

My husband and I need to buy a second car, and we've been figuring out what the best solution for us is. Our initial plan was to buy a new car and drive it for over a decade. However, we found out that a friend of ours is selling their old car because they're moving to NYC, and we've pretty much decided to buy that instead. It's old and cheap, but in decent condition, so we should get a few years of driving out of it. In the meantime, we plan to start making monthly "car payments" into an online savings account. Hopefully, by the time we need to buy our next car, we'll have a nice lump in there to cover most, if not all of the price. Letting our car savings accrue interest is obviously better for us than paying interest on a car loan. What do you think?

Oh, and before I saw this car discussion I meant to comment to say, keep up the good work! I check here daily, and I find your advice very useful.

RDS said...

Tuuli,

Thanks for your comment. Buying an older but reliable car - especially from someone that you know and trust - can be great way to get a good deal on a car. I really like your idea of making an artificial car payment so that you will be financially prepared to buy your next car.

I have been toying with publishing a post on buying a car. Given the interest, perhaps I should write it sooner, rather than later.

RDS