“The rich rules over the poor, and the borrower becomes the lender’s slave.” – Proverbs 22:7
One of the reasons I write this blog is to help you understand the potentially negative long-term effects of poor financial decisions so you live a better more peaceful life. The quote above affirms reality. Are you spending more than 40% of your life working just to realize at the end of each and every month you have nothing left to save? If so, you are not alone. You are literally slaving away to pay the lender – typically, a bank and the shareholders. Keep reading if you want to move from slave to lender.
But before we jump into bad debt discussions, if you are just joining us, we are diving into a series entitled Five Pillars of Financial Freedom. If you missed it, check out the introduction to the series. Alright, let’s jump into a discussion on bad debt.
“… 50% of people are woefully unprepared for a financial emergency, new research finds. Nearly 1 in 5 (19%) Americans have nothing set aside to cover an unexpected emergency, while nearly 1 in 3 (31%) Americans don’t have at least $500 set aside to cover an unexpected emergency expense.”
The above statistics cited in a Marketwatch story show that a large portion of Americans work a significant portion of their lives and have nothing saved to cover an emergency expense. This is a serious problem. Why? Because unexpected expenses are exactly what cause people to take on bad debt.
You know that sinking feeling when you receive the emergency room bill, the quote to fix the car, or you need to pull together the first month and last month’s rent to move to a new home. If you don’t have $500 set aside for emergencies, then how in the world are you going to pay to fix your car? You absolutely need to do everything you can to save some portion of your paycheck each month. That is step one to avoiding bad debt. There is a reason personal finance talking heads so strongly advocate for an emergency fund of three to six months of your income. Your first step towards becoming extremely wealthy is extremely unsexy – save $500 and never for the rest of your life touch it unless you have an emergency and have no other money to pay for said emergency.
Why is this $500 thing so important? Because if you don’t have the cash, then you borrow and become a slave to the lender. If the lender happens to be a credit card company and you can only make the minimum payment on the $500 charge, let’s take a look at the consequences. Assuming the rate is 18% per year and the minimum payment is all interest plus 1% of the balance, then you would pay $198.71 in interest over the course of 47 months. 4 years!!!
If it isn’t bad enough that you are paying almost 40% more than your initial cost of $500, you are also forfeiting the investment returns you could have achieved by putting $15 per month for 47 months into an investment. By using the credit card, you paid $700 and were left with zero in the ol’ piggy bank. By not using the credit card, you paid $500 up front, but then you put $858 ($15/mo. for 47 months compounding at 10% per year) in Ms. Piggy’s purse. That is a huge difference at the end of 4 years – $0 or $858.
Credit cards are bad debt – if you don’t pay them off each month stick them all in your toaster.
So what is bad debt? Glad you asked. Bad debt is any debt that prevents you from growing your assets. For example, a mortgage is not bad debt because it permits you to grow your assets from the amount of your down payment to eventually the fair market value of your home once you own it outright. A credit card payment is bad debt because, as we saw above, it leaves you poorer after having paid it off.
A car payment can be bad debt, but it might not be. If you can get a car loan at 2.9% annual percentage rate, then that is a good financial choice. Why? Because you could trade $10,000 for the car, or you could borrow the money and invest the $10,000. If you invest the $10,000 and make 6% after taxes, then at the end of a 7 year period (which is the period over which you will pay the auto loan off), you would have $15,036. On the other hand, borrowing the money and paying off the car over 7 years, you would pay $11,061.35. By simply borrowing the money, after 7 years, you are about $4,000 wealthier than had you just paid cash up front. That’s huge!
In conclusion, stay the heck out of high interest debt situations. Anything that is greater than 10% you should avoid. Shoot, if you are going to borrow money at 10% or 15%, come see me first. But seriously, avoid high debt like the plague because there aren’t many things that will ruin your ability to become financially free like bad debt. When determining whether to borrow money, ask yourself, “when I’ve paid this debt off, will I have an asset that has the potential to increase in value?” If the answer is yes, then borrow away. If the answer is no, then strongly consider not borrowing unless it is for a necessity and you can get a rate lower than what you could earn in the stock market (see car example above).
Stay tuned because in the next part of our series I am going to explain why owning a home is a road to riches.
Feel free to contact me on Twitter @jordanurness.