Every time you borrow money, you’re robbing your future self. –Nathan W. Morris
If there’s a topic that divides personal finance authors more than anything, it’s debt. On one end, Dave Ramsey and his followers abhor the use of debt in every circumstance. He recommends that people don’t use credit cards, pay no attention to their credit score and pay cash in every circumstance. He even suggests that his followers try to save up and pay cash for their first home if they can swing it. On the other end, there are authors like Robert Kiyosaki and Pamella Yellen who advocate strategies like buying rental real-estate with no money down and borrowing from whole life insurance policies as core part of your personal finance strategy. To them, debt is a tool that lets people leverage other people’s money to create wealth. While there are personal finance experts that advocate on both sides of the use of debt, the proper use of debt lies within the middle of these two extremes.
Americans Love Debt
People in the United States love to take on debt. We borrow through credit cards, mortgages, payday loans, home equity loans, personal loans, in-store credit, student loans, car loans, title loans and many other financial products to pay for just about everything. The typical American family now has an average of $15,355 of credit card debt and average total debt of $129,579 (http://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/). 72.1% of Americans have at least one credit card 16% of Americans have at least five credit cards (http://www.creditcards.com/credit-card-news/ownership-statistics-charts-1276.php). 80% of all Americans are in debt of one kind or another. Companies make it very easy for us to sign-up for debt and many Americans are more than happy to use the credit that’s made available to them.
Want to Become Wealthy? Avoid Debt.
While taking on a manageable level of debt to purchase a home or fund your education can be a good idea, many people take on far too much debt. When you have a lot of consumer debt, it is very difficult to become wealthy because of the interest payments you have to make each month. If you have $50,000 in credit card debt at a 15% APY, you are paying $625.00 per month in interest to service that debt. That’s $625.00 each month that can’t go toward reducing debt, can’t be put away in savings and can’t be invested for the future.
Albert Einstein is quoted to have said that “Compound interest is the most powerful force in the universe.” When you invest your money into stocks and bonds, the power of compound interest is working in your favor. You receive interest and capital appreciation on your investments regularly and over time the value of your investments will grow exponentially. When you borrow money, compound interest is working against you. You are being charged interest each month for the privilege of borrowing someone else’s money. The interest charges that you pay on your personal debt make it harder for you to get out of debt because a major portion of your payment isn’t going toward reducing your principal balance.
Wealthy people recognize the true cost of borrowing through consumer debt and generally avoid using it. A while back, a survey was done of the 400 wealthiest Americans as determined by the Forbes 400 list. When asked about wealth building, a whopping 75% of them said the best way to build wealth is to become and stay debt free (https://www.daveramsey.com/blog/7-characteristics-of-debt-free-people). If you want to become financially independent over the course of the next decade, you should take the advice of the Forbes 400 and work to eliminate any personal debt that you carry.
I personally have no debt to my name. My wife and I own our home free and clear and have paid cash for both vehicles we own. We do use credit cards, but pay them off in full each month. All of my businesses are funded entirely out of operations and we do not use debt in any part of our business. I have personally taken out a student loan and a mortgage on my home, but I paid both of those off as quickly as I possibly could. My wife and I have not had any personal debt since we paid off the mortgage on our current home more than three years ago.
“Good Debt” and “Bad Debt”
A lot of personal finance authors will break down debt into “good debt” that’s tied to an appreciating asset, like a home, a business, or a college education and “bad debt” that’s used to finance a depreciating asset, like credit cards, payday loans and car loans. While some types of debt are certainly worse than others, I don’t think that any debt should be characterized as “good debt.” Calling any kind of debt “good debt” encourages people to borrow money that they might otherwise not borrow and minimizes the perception of risk that’s associated with debt. I like to think of mortgages, student loans and other types of “good debt” as “necessary evil debt.” It’s not the worst thing in the world to buy a home with a mortgage, use a student loan to help pay for college or get financing for your business, but you should always minimize the amount of money that you borrow and try to get the most favorable terms you can.
Here are some considerations for the various types of “good debt” that you may want to use:
- Mortgages – Most people will need to take out a mortgage to pay for their first home. With interest rates near historic lows, it may be tempting to borrow more than you might otherwise. Keep your mortgage payment under 25% of your take-home pay so that your mortgage payment doesn’t consume too much of your monthly income. If at all possible, get a 15-year fixed-rate loan. Your payment will be slightly higher than a 30-year loan, but you’ll shave off a full fifteen years of payments on your mortgage.
- Student Loans – If you are going to borrow money for college, make sure that your degree is preparing you for a career that will enable to you to pay off your student loan debt. Only borrow money through the federal student loan program and avoid private loans like the plague. Never borrow more for your education than you expect to earn in your career in the first year after you graduate. I also strongly recommend attending an in-state public university to reduce the cost of your education. Attending more-expensive private schools almost never makes sense from a financial perspective.
- Business Debt – While avoiding business debt is preferable, it may be necessary to take on debt depending on the type of business that you have. For example, you might need some short-term financing to pay for inventory that can be repaid when you receive orders from your customers. Avoid financing your regular operating expenses through a line-of-credit or a credit card. Your regular operating expenses should always be funded out of cash flow. If you have to dip into a credit card to make payroll or cover another regular expense, you’re headed for trouble.
- Debt Consolidation Loans – If you are working to reduce your debt, you may be able to use a debt consolidation loan to lower the amount of interest that you pay on your debt. Taking out a debt consolidation loan will only work if you stop borrowing money. If you keep racking up credit card debt after taking out a debt consolidation loan, you will only make your debt problem worse. Never use a home equity loan for debt consolidation, because that turns unsecured debt into foreclosure debt if you aren’t able to make your payment.
Here are some types of debt that you should generally avoid:
- Auto Loans – Buying a car, especially a new one, can be an incredibly expensive proposition. It just doesn’t make sense to pay interest for the privilege of owning an asset that’s going down in value. Pay cash for a used car if at all possible. If you can’t afford to buy a vehicle with cash, purchase the least expensive reliable vehicle you can and pay it off as soon as you can.
- Payday Loans – These short term loans prey upon low-income consumers and charge annualized interest rates of 400% or more. No one should ever take out a payday loan under any circumstances.
- In-Store Financing and Store Credit Cards – There’s a reason that every major department store asks you if you want to sign-up for their credit card at check out. Store credit cards are a great deal for retailers and a horrible deal for consumers. Store credit cards have much higher interest rates than regular credit cards. These cards also come with very unfavorable terms and often do not offer any rewards. You are almost always better off paying for purchases with your own credit cards
- Credit Cards – It’s totally okay to make purchases with a credit card, just be sure to pay off the balance each and every month. Because you never earn a return on your purchases, credit card debt falls into the “bad debt” category. Credit cards also have higher interest rates than other types of loans and your debt level may rise over time if you only make the minimum payment.
- IRS Debt – If there’s anyone that you don’t want to owe money to, it’s the Internal Revenue Service. They should always get paid first after taking care of the basic necessities of life. If you don’t file your taxes or simply fail to pay them, you’ll be hit with additional fees and penalties that add up quickly. The IRS can also place liens on your home and any other assets that you have if you owe them money.
- Home Equity Loans – Home equity loans can offer very attractive interest rates, but they also put your home at risk. Like with a mortgage, your lender can foreclose on your home if you fail to make the payments. It rarely makes sense to put your home at risk for the privilege of borrowing money, so I generally recommend avoiding home equity loans.
With so many creative financing options entering the market, there are simply too many types of “bad debt” loans to list. There are many other types of “bad debt” loans that I did not list above, such as signature loans, personal loans from a bank, pawn shop loans, title loans and appliance loans. These loans should also be avoided. If at all possible, only borrow for the four categories of “necessary evil” debt that I listed in the previous section. For everything else, save up and pay cash for your purchases.
Remember that every additional loan that you sign-up for adds one more mandatory monthly payment to your budget each month and reduces your ability to save and invest toward your long-term savings goal. If you want to achieve financial freedom, debt should not be a regular part of your life. Become and stay debt free so that you can save and invest more money each month and reach your goal of financial freedom faster.
If you have a lot of debt…
If you are deeply in debt or are behind on your bills, you can still begin your ten-year turnaround even though you’ll be starting from behind. I truly believe that anyone can dramatically transform their finances over the course of ten years, regardless of where they are starting at. When I began my ten-year turnaround, I had credit cards and student loan debt to deal with. I was able to pay those off during the first two years of my turnaround and have since gone on to build a significant amount of wealth.
If you are in debt, follow the instructions in chapters 1-4 to increase your income over time and begin living on a budget. With a larger income and a spending plan in place, it will be much easier for you to pay off your debt. If you’re not sure how to get out of debt, go pick-up Dave Ramsey’s The Total Money Make-Over book and sign-up for a Financial Peace University class. Dave Ramsey’s material is highly-motivating and offers a step-by-step plan that anyone can use to get out of debt. Dave Ramsey teaches a strategy called the “debt snowball” which involves paying off debts from smallest to largest. You can learn more about snowballing debt at http://www.daveramsey.com/blog/how-the-debt-snowball-method-works. Once you have worked through your debt, your monthly cash flow will be freed up and you can begin to apply the investing and wealth building strategies outlined in chapter 7 of this book.
Make This Personal Debt Commitment:
I _______________ (your name), hereby promise to borrow as little as possible during my ten-year turnaround. I recognize that having debt will severely hinder my ability to build wealth and attain financial freedom. I will only take on debt for the purchase of a reasonable home and for my education and only if absolutely necessary. I will pay off my credit cards each and every month. I promise to get and stay out of debt so that compound interest is working for me and not against me. I will not get a car loan, a payday loan, a store credit card, in-store financing, a home equity loan, a personal loan or any other type of debt for any purpose under any circumstances. Period.
______________________ (your signature)
A Note for Christians about Debt
The Bible does not explicitly endorse or forbid a Christian from borrowing money, but it does offer explicit instructions for Christians that are in debt. The Apostle Paul wrote in the book of Romans that we should “Let no debt remain outstanding, except the continuing debt to love one another, for whoever loves others has fulfilled the law” (Romans 13:8). The Book of Proverbs echoes the Christian’s responsibility to repay debt: “The wicked borrow and do not repay, but the righteous give generously” (Proverbs 37:21).
If you are a Christian that’s in debt, work diligently to get out of debt so that there is nothing hampering your ability to answer God’s calling on your life. The Bible says that a borrower becomes a servant to their lender (Proverbs 22:7). Jesus said that “No one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other. You cannot serve both God and money” (Matthew 6:24). When you have to service a large amount of debt, you may not be able be obedient to God’s calling. What if God were to call you to give to a specific cause? What if he were to call you to serve as a short-term missionary or work in ministry job? Would you be able to afford to say “yes” to the call that God places on your life? If the answer is “no,” begin working to get out of debt so that you can respond to any calling that God places on your life.
The Proper Use of Credit Cards
Carrying a balance on a credit card is never a good idea, but that doesn’t mean you should avoid using credit cards all together. If you see credit cards as “free money” or otherwise regularly finding yourself carrying a balance, don’t use credit cards. The interest charges you will pay each month will negate any of the benefits of using a credit card. If you can pay off your credit card each month like clockwork, there are some financial benefits to paying for purchases with a credit card.
Here are some reasons that you might want to pay for your purchases with a credit card:
- Rewards – There are multiple credit cards that will give you 2% cash back. Using one of these credit cards is tantamount to getting a 2% discount on every purchase that you make. If you put $5,000 on your credit card each month, that’s $100.00 in free cash you wouldn’t have received otherwise. As of mid-2016, the best cash back rewards credit card is the “Citi Double Cash” card, which effectively pays 2% cash back on all purchases. These offers tend to change over time, so visit websites like NerdWallet.com and CreditCards.com to find the best current offer. If you travel frequently, you may be able to leverage rewards to get even more than 2% cash back in travel. Visit thepointsguy.com and www.abroaders.com for resources on travel rewards for credit cards.
- Chargeback Rights – If you have a problem with a purchase or if something you order online doesn’t show up, you have the right to file a chargeback within 60 days of the purchase with your credit card company. More often than not, the credit card company will side with you over a merchant because you’re their customer.
- Fraud Protection – If your credit card is ever lost or stolen, you are not responsible for any fraudulent charges that are made under your card. You just have to call your credit card company, they will cancel the charges and issue you a new card. If your debit card is stolen, your checking account will get wiped out. Then, you’ll have to fight with your bank to get your own money back. It’s much better to pay for purchases with a credit card than a debit card for this reason alone.
- Travel Benefits – Many credit cards offer a number of additional benefits for travelers, such as rental car insurance, trip cancellation insurance, lost luggage reimbursement and roadside assistance. A few cards will even get you into airport lounges for free.
- Purchase Protection Benefits – Many credit cards will extend a manufacturer’s warranty by another 12 months and will offer you price protection if something you buy goes down in price.
I truly believe that using a credit card is the best way to make purchases, as long as you have the discipline to only purchase what’s within your budget and to pay off your balance each month. Between my business and personal purchases, I earned more than $10,000 in credit card rewards in 2015. I was able to use those rewards to send my parents to Las Vegas for a week (http://bit.ly/matt-points-and-miles) and attend a number of conferences without having to pay for airfare or a hotel. I’ve been able to use airport lounges for free and have gotten reimbursed after an airline couldn’t find my luggage. I can’t count how many times that chargeback rights and fraud protection have saved the day from misbehaving merchants and fraudulent charges. While paying with a credit card won’t get you dramatically closer to financial freedom than paying with cash or a debit card, the rewards, additional perks and fraud protection make credit cards my preferred payment method.
Building Your Credit
If your credit score is already in good shape, feel free to skip over this section. If you have bad credit or have never established credit before, there are concrete action steps that you can take to start building or rebuilding your credit score. If you have never taken out a loan before and want to start building your credit, your first step is to visit a local credit union and inquire if they have a “fresh start” program that may allow you to get a credit card without a credit history if you open a checking or savings account with them. Alternatively, you can sign-up for a secured credit card, which requires a cash collateral deposit that becomes the credit line for that account. For example, if you deposit $500.00 into collateral account, you will have a credit limit of $500.00. Use your new credit card sparingly and pay off the balance each month. The credit card company will report your payment history to the three major credit bureaus and your score will rise over time as you establish a track record of on-time payments.
If you have bad credit, you have probably noticed ads from companies that will promise to fix your credit or help you establish a new credit identity. Many of these companies are outright scams. If any company promises that they can remove accurate negative information from your report, requires you to pay up-front or suggests that they can get you a new credit identity, run in the opposite direction. You are better off working to repair your credit yourself, by working through and settling any bad debt that you may have, fixing erroneous information on your credit report, and establishing a record of on-time payments in the future. While there is no quick fix for bad credit, FICO has produced a guide that provides tips to improve your credit score over time located at http://www.myfico.com/crediteducation/improveyourscore.aspx.
Protecting Your Credit
The information on your credit report is now used for far more than whether or not you are approved for a loan. Even if you never plan to borrow money again, you should still regularly monitor your credit report because your credit score is used by insurance companies, cell phone carriers, apartment complexes, utility providers and many other companies. You should also monitor credit so that you can spot any fraudulent accounts that have been created by identity thieves in your name.
Here are the three steps that I believe everyone should follow to protect their credit:
- Freeze Your Credit – The best way to stop identity thieves on their tracks is to put a security freeze on your credit reports with the three major bureaus—Equifax, TransUnion and Experian. A security freeze will prevent anyone from applying for credit in your name. If you need to apply for credit, you can temporarily lift the security freeze for 30 days so that a company can check your credit. While freezing your credit can create a bit of hassle when you want to apply for a loan down the line, the $30.00 you’ll have to pay to freeze your credit is the cheapest form of identity theft insurance you can buy. Clark Howard has put together an excellent guide on freezing your credit located at http://www.clarkhoward.com/credit-freeze-and-thaw-guide/. If you freeze your credit, make sure to write down the pin numbers each of the bureaus give you and put them in a safe place. It can be very hard to unfreeze your credit file without having the pin numbers they give you.
- Check Your Credit Reports Annually – Every twelve months, you can check your credit reports from Equifax, TransUnion and Experian for free by visiting annualcreditreport.com. Annual Credit Report is website that the three major bureaus were required to setup as part of the Fair Credit Reporting Act. At the same time every year, you should pull your credit reports to make sure they are accurate and that no fraudulent accounts are showing up on your credit report.
- Get Free Credit Monitoring from Credit Karma – Credit Karma is a website that provides you free credit scores from TransUnion and Equifax, as well as free credit monitoring services that will alert you when changes are made to your credit reports. Like Mint.com, Credit Karma makes money by recommending credit cards, mortgages and other financial products. Because you can get completely free credit monitoring services from Credit Karma, it doesn’t make sense to pay a monthly fee for credit monitoring services with another company.
If you find that an account has been opened in your name that you didn’t authorize, you should take immediate action to resolve the matter. The FTC has put together an action guide on what you should do if your identity is stolen. The guide, titled “Taking Charge: What to Do if Your Identity Has Been Stolen” is located at https://www.consumer.ftc.gov/articles/pdf-0009-taking-charge.pdf.
Debt can be an incredible barrier for anyone that wants to build wealth. If you are making large monthly payments to service debt, your ability to save and invest for the future is significantly diminished. Commit to minimizing any future borrowing and only borrow money for the purchase of a home, to fund your education (within reason) or to fund the growth of your business (if you have one). If you are in debt, use the “debt snowball” strategy to work through any debt that you have. Once you become debt free, your monthly cash-flow will be freed up and you can begin to use that money to quickly build wealth using the strategies outlined in Chapter 7.
- Commit to minimize any future borrowing and commit to only borrowing for your home, education or for your business.
- If you are in debt, use the “debt snowball” strategy to pay off any debt that you have.
- Freeze your credit report and setup free credit monitoring services through Credit Karma