Debt Management Strategies
What is Debt?
Debt is bad for so many reasons. Any time you add debt you are adding risk. While risk is not always bad you want to make sure you only take necessary risks and that you understand all of the potential consequences.
Let’s go straight to the bottom line. Debt is bad. Some people will argue with me on this point, but most people should consider all debt to be bad debt. We’ll talk about paying off your debt in a minute, but first let’s talk about not getting into debt (or not getting into any more debt). Why is debt bad? Because you are spending tomorrow’s income today.
1. Debt takes away your choices
Think about it. What if you are offered the perfect job in the perfect location, but the pay is not very high? Still, it may be your dream job of testing video games or choosing the fall line of clothes for a retailer. But if you have a huge mortgage, a large car payment and a lot of credit card debt, that drop in salary will mean you cannot afford to take the perfect job.
2. Debt reflects on your character
Now stop here for a moment. You will hear me say form time to time that money is a behavioral issue, not just a math issue. The way you handle money is a reflection of your character at a deeper level. Think about it. The banks, insurance agents, landlords and employers have all figured out that people who are not responsible with their money are also not responsible in other areas of their lives. Take that lesson to heart. If you are in financial trouble, there may be deeper issues at stake.
3. Debt can affect your ability to get hired!
Remember our discussion about credit scores? Employers are not only checking social media sites but also checking credit reports as a way of measuring how responsible people are. Statistically people with bad credit tend to make for bad or problem employees. How ironic would it be if spending more money than you can handle kept you from getting the very job that would give you the ability to pay it off?
Employers are checking credit reports as a way of measuring how responsible people are. What that means to you is that irresponsible spending that leads to a lower credit score could prevent you from getting a job!
4. Debt prevents wealth
Do you know what your greatest wealth-creating tool is at your disposal? It’s your income. No matter what the stock market is doing, or what direction the economy is going, having a solid income can help you continue to build wealth. Do you know the number one way to neutralize or destroy your income, other than losing your job? Debt.
If you have $2,000 coming in every month, but your debt payments are $1,500, then you really only have $500 disposable income coming in. It’s hard to build wealth when you have just $500 per month to work with (which you will need to pay for all of your regular expenses such as food, utilities, etc.). Even if you only have $500 worth of debt payments that means you have $500 less to invest towards your future.
5. Debt creates more debt
What happens if you keep borrowing? You think you can’t because you are maxed out? Well, you’ll start getting additional credit card offers and as long as you keep making your payments, no matter how difficult it may be, your maxed out cards will increase your credit limit. You could keep borrowing and borrowing, easily working your way up to $5,000 – then $10,000 – then $20,000 in credit card debt and so on.
Next thing you know your monthly payments are so high the only way to pay your bills is to use your credit cards until they are maxed out. You will be looking for credit card offers, personal loans like the ones advertised on television, or other poor alternatives such as car title loans. This is a downhill financial cycle in which I hope you never find yourself trapped.
6. Debt creates stress
During an economic downturn, who is affected the most? People with debt or people who are out of debt? While any economic recession or downturn is scary to most individuals and families, those who owe lots of money are the ones most affected and stressed.
If you owe nothing on your car, and owe nothing on your home, and owe nothing on credit cards, what do you have to fear if the price of your house goes down? What happens if you lose your job? Sure, you need to find another job to make enough money to eat and pay the utilities. But it is easy to find a new job right away that pays enough to cover the essentials. It is very difficult and stressful to find a job right away that pays enough to cover the essentials, plus the rent, car, student loan, and credit card payments.
Debt Eats Away Your Future Income
By getting yourself into debt, not only do you sacrifice your future income, but you also are paying more for everything once you include the interest charges. You are selling away your choices. If you have $1,000 cash you have many choices of what to do with that money. Once you spend it you have fewer choices, but at least you can go earn more. However, if you borrow another $1,000, you have even fewer choices, because now some of your future money has been spoken for. For instance, you cannot quit your job since you first have to earn that $1,000 you borrowed. If you lose your job, you are forced to get another one immediately, even if it is not the one you want, since you have to make the payments on your debt.
In addition, you are not saving anything because you are too busy making payments. What could be worse than spending the next three years waking up at five o’clock in the morning, commuting for 30+ minutes, staying late at the office, etc. only to look back and realize all you have to show for it is a computer that no longer works and about $790 in debt? Avoiding debt (this includes avoiding new debt if you already have some) is the first step towards reaching any financial goal. Paying off your current debt is the second.
Okay, it seems like everybody has debt, so why is it so important to pay it off? To begin, not everyone has debt. Many wealthy people you see do not have any debt. In fact, many people were only able to acquire all of their wealth because they had no debt. You have already seen how debt takes away your choices. Most people who earn their way into millionaire status do so by saving heavily, spending lightly and avoiding debt as much as possible. Let’s take a look at some numbers that illustrate how damaging debt can be.
Assume for a moment that you have $3,000 in credit card debt at 16% interest. Your monthly payment is probably about $60. If you pay just the $60 minimum payment, $45 goes towards interest and just $15 goes towards your principal. This means next month, assuming you do not add any other charges onto the card, your balance will be $2,985. If you continue to make only the minimum payment it will take you over 29 years to pay off the card! By the way, you will have paid $5,300 in interest on your $3,000 charge over that time period, and that is under the assumption you never made any new charges. Now are you ready for the real kicker? If you would have been saving those interest charges during that same time period and earned an average 8% return, you would have $30,000.
Let’s recap. For the past 29 years you have paid over $5,300 in interest to a credit card company and you have exactly zero dollars to show for it. If you had invested the interest only portion of your payments for the last 29 years instead, you would have $30,000 in savings.
Here is another example. Let’s assume you have a car that runs well, but it is six years old and out of style, so you decide to trade it in. You buy a new car for $21,000 minus the $2,000 trade-in for your old car, so your loan is for $19,000 at 6% for five years. At the end of the five years your car will be worth about $4,000. Your total payments over the five years were $22,039. In the end, the car cost you $24,039 including interest. If you would have held onto your old car instead, and invested those payments at 8%, you would have $27,000 in savings.
In other words the $21,000 car actually cost you $24,000 in five years. Ouch. Of course, you may be thinking, “So I paid a little extra for the car, what is the big deal?” The big deal is that instead of having $27,000 in cash the next time you want to purchase a car, you will have to get another loan, and deal with another trade-in and the vicious cycle continues.
How Do I Do It Differently?
Of course there are many times in our life where we need debt. Many students need loans to finish college, most people can’t buy a home without a mortgage, and many of us find ourselves financing car after car throughout our lifetimes. Well, we’re going to look at how to break the debt cycle, restore your credit (if necessary) and learn to pay for everything with cash.
- Get out of debt
- Pay off your debts in the best possible order
- Use your money wisely
- Learn to spend
- Learn to save
- Learn to invest
Why Is Getting Out of Debt So Important?
In our society, we are all about choices. You can choose four different types of cheeses for your sandwich, 50 flavors of ice cream, or 2,000,000 flavors of coffee. Cars, cell phones, iPods, laptop computers and even washers & dryers come in multiple colors. We love choices. That’s one of the ways we celebrate our freedom. Unfortunately, too many of us voluntarily give up our freedom by giving away our choices. We choose to spend more than we have today and have to make up for it tomorrow, and the next day, and the day after. Choose debt or choose freedom; it’s up to you.
Imagine for a moment that you have no credit card payments, no personal loan payments and no student loan payments. Now imagine eliminating your car payment(s). Finally, look at where you would be every month if all those payments were gone, and you also had no house payment. Wow! For many people, that would be like getting a 40% pay raise or more! In other words, you would have 40% more money every month to spend.
What would you do with a 40% pay raise? Let me know in the comments below.