Stay Out (of Debt)

Dec 13, 2001 |Todd Temple

The holidays can really sink your finances. This month's classic Money Talks column offers some tips for avoiding the debt trap.

I'm about to tell you stuff that certain people don't want you to know. Specifically, people who make a living off the consumer debts of others. That's a lot of people. The money you pay in interest on credit cards, car loans and installment plans pays salaries for legions of bankers, retailers, car dealers, collection agents and lawyers. And it makes a lot of these people very rich.

To keep their paychecks coming, the folks in the debt industry make a very strong argument in support of consumer debt: It keeps the economy growing. That's because you've got to keep working to make your debt payments, which provides employers with motivated workers to make and sell the things that more and more people can afford because they're borrowing money to pay for them. That's a good thing for everyone, right?

Not so fast. Yes, it's a good thing ... for them. But economies can do just fine without consumer debt to fuel them. Whether you use cash or credit, you're still a consumer. You still have to buy stuff, which keeps sellers in business and employees on their payrolls — employees who spend their paychecks on more stuff. The money still flows. The economy survives and grows. It may not grow as fast because you're not buying as much stuff. But it works more efficiently because you've cut out one unnecessary middleman: the creditor.

So you can see why certain people don't want you know what I'm about to tell you: How to cut out that expensive middleman from your own economy. I've got three rules to help you do that. If you're debt-free right now, practicing these rules will help you keep it that way. If you're already in debt, you'll want to start applying these principles immediately to keep you from digging deeper.

1. Put together a money-management system ... and use it.

Debt is a decision you make: You sign an agreement or charge slip, or choose not to pay a credit card balance in full. Most people make that decision because they want or need what they're buying, but don't have the money to pay in cash.

I'm not trying to be mean here, but if that's your reason, you're probably not managing your money very well. A money-management system helps you assign portions of your paycheck for each priority. If what you're buying is important enough, it's listed under one of your priorities, and you're setting aside cash to pay for it. You don't use money intended for other priorities. For big ticket priorities, that means planning months or years in advance. For example, to take that $600 trip in July, you set aside $100 each month for the next six months. It's a priority, so you plan for it.

But what if you can't afford to set aside that much cash? Then stay home. Because if you pay for the trip on your credit card, you'll still have to come up with a hundred bucks a month ... after you've taken the trip. Make that $105 — there's the interest now. Either way, you're making monthly payments. When you make those payments to yourself before you buy, you earn interest instead of pay it. This fact is so plain you'd think people would stop using the "can't afford to save" excuse. Yet I know millionaires who haven't figured it out yet.

Ahh, but how about this excuse? — You don't know about the expense until it's too late to save up for it. Sorry, but nine times out of ten, this one's lame too. Let's face it: Life is full of expensive surprises, good and bad, so you plan for them. Set aside money each month that doesn't have to be spent on the "predictables." Then you can afford to be spontaneous.

2. Never borrow money to pay for things that go down in value.

The opposite of this rule is the definition of consumer debt: investing in a depreciating item with borrowed money. That includes most cars, vacations, food, clothing, toys — virtually anything you buy with a credit card or installment loan.

Let's look at consumer debt in light of the rules of investing. Rule #1: Buy things that go up in value. That's what the stock market and real estate and baseball cards are for. Rule #2: Rent your money to others so they can practice Rule #1. That's what bonds and savings accounts and loan-sharking are for. Consumer debt is the bizarre combination of these two rules turned upside down: Rent other peoples' money to buy things that go down in value. As an investment strategy, it approaches the pinnacle of silliness.

Here's why: Let's say you've got your heart set on a fine little stereo system on sale at the consumer electronics store for $450. You don't have the cash, so you charge it on your credit card, which has an 18% annual interest rate. You pay it off in a year, which comes to twelve monthly payments of $41.25. Brace yourself, because your upside-down investment has lost money in three exciting ways:

  1. Interest: By taking the whole year to finish off the credit card debt, you paid $45 in interest.
  2. Opportunity Cost: This is the money you "lost" because you paid interest instead of earning it in a savings account. After all, you could have been sticking $41.25 in the bank each month and then paid for the stereo in cash. In round numbers, you would have earned about 10 bucks in interest. It's not much, but in figuring the true price of the stereo, it counts. That's opportunity cost.
  3. Depreciation: The stereo's a year old and your roommate spilled coffee on it while listening to that speed-polka station, so now that's the only station you can get, which was just fine when you were pulling an all-nighter for finals, but now you hate it. You might be able to sell the stereo to your kid brother for $100. So you lost $350 in depreciation.

All told, the stereo cost you $505 in principal, interest and opportunity cost. And now it's worth $100. Maybe it's just me, but that seems like an awfully high price to pay for something that doesn't last. What's the alternative? Make your payments before you buy — to your own savings account, where you can earn interest instead of pay it. And while you're waiting, you can decide if you really want to spend that much after all. Or maybe the prices will drop so you can bet a better deal. Or maybe your new roommate will come equipped with a stereo.

The toughest consumer item to buy with cash is also the biggest thing: a car. Actually, it's not so tough if you don't mind driving a $300 car. But buying a good car, a safe car, a car equipped with accessories such as brakes and steering — that takes a bit more cash. The good news is, you can afford to buy a reliable, good-looking and totally fine used car if you do a bit of financial planning and some basic research. We'll save the details for another column, so hold off on signing that car loan till we have a chance to chat about the alternatives.

Whatever you do with your money, the basic rules of investing still apply: Buy things that go up in value. Spend as little as you can on things that depreciate. And when you do buy things that go down in value, never ever rent someone else's money to do it.

3. Pay every bill in full.

The best thing about a credit card is that it allows you to buy stuff without hauling around a wad of cash. A few weeks later, you get the bill and write a single check for everything you bought. You've paid the balance in full, and not a dime in interest. It's a great convenience...and a dangerous trap.

Maybe you had the money in the checking account when you bought the stuff, but by the time the bill comes around, it's gone for other things. Like food and rent. Or you counted on the grace period to carry you while earning the money to cover the bill. But you mistimed the billing cycle or they cut back your hours at work and now you can't cover the balance.

In either case, your best "no borrowing" intentions are shot. You pay what you can afford, promising yourself that you'll retire the balance next month. Sound familiar? Then you know where this leads. A few months later, you've given up hope. The balance keeps growing, and every new charge incurs interest from the date of purchase — you've lost out on the grace period. Now the balance is so high that it's tough enough just scraping together the minimum payment. Then you hit your credit limit and start running up the balance on another card. As the bills pile up, you realize it's time to get spiritual: Buy a lottery ticket and pray for your numbers to come up.

There's really just one way to avoid this disaster: Don't let it start. If you're using a decent management system, you'll already have money set aside for the purchase before you make it. That rule applies whether you pay with cash, check or credit card. If the money isn't set aside somewhere, before you buy, don't buy. If that's a real problem for you — if the float is the only thing carrying you to the next paycheck — then you need to put away the card and start living on a cash budget. That seems awfully harsh, but the alternative too often leads straight into a debt dependence as vicious as a drug habit. You don't want to go there.

Did you ever get caught doing something bad in class, and the teacher made you write on the board a hundred times your promise of abstention? I will not juggle lab mice ... I will not juggle lab mice.... Well, maybe it's time to go back to that board and write I will not carry over a balance ... I will not carry over a balance.... The trick is to make even the thought of doing it so unpalatable that you'd pawn your roommate's stereo before you would allow a credit card balance to go unpaid.

Peace of Mind

There you have it: Three basic rules that will save yourself years of grief and thousands of dollars in fees from those middlemen. You'll be earning interest instead of paying it. And best of all, you'll have that delicious peace of mind that comes from knowing that creditors don't have a vote in how you spend your money. That vote is for you and God — the two people who know you best.

One more thing. If you're in debt and looking to get out, don't worry, I haven't forgotten you. The avoidance rules will keep you from digging deeper, but they're not enough to dig you out. After all, if you could pay off all your debts in full this month, you would. So hold onto that desire till next month. I'll give you a workable plan to start you on the path toward debt freedom. I've traveled it myself. I'll show you where to step.

Copyright © 1999 Todd Temple. All rights reserved.

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