Have you ever taken a vacation with your friends and put it on a credit card – promising to pay it off later? Did you pay it off later? If you’re like many of my clients, the answer to these questions is often Yes and No, respectively. The good news is you are not alone – the bad news is that you only hurt yourself when you take on bad debt without really understanding the consequences ahead of time.
Let’s look at a quick example to show you what I mean. Say you want to take a road trip to New Orleans with your friends and you end up putting $1,000 on your credit card to pay for it. Assuming that you put this trip on your card in the first place because you could not afford to pay for it out of your normal cash flow, you likely can only squeeze by with the 3% minimum payment. At $30/month and assuming an interest rate of 25%, it would take you 132 months (that’s 11 years!) to pay the card down and in the end you would have paid $2,498.82 on a $1,000 trip. This is a textbook example of “bad debt.”
Not all debt is bad. Taking a loan to buy your first house, get a new a car, finish your education – these are all liabilities that can improve your life. Not everyone wants to be a homeowner but for those who do, this is a major milestone and because many people purchasing a home for the first time don’t necessarily have the cash on hand to buy it – a loan can be an appropriate way to meet this goal. Depending on where you live, a car can be a vital necessity for getting you to and from work every day so financing a purchase like that can also fall on the “good debt” side of the scale. Although the subject of student loans makes most people in Generations X and Y a little green in the face, these too can be a necessary evil on the path to building your ideal life.
A good place to start with any loan is making sure that you are not taking on more debt than is needed to meet your objective. For example - if you just need a car to get you to and from work and you’re making $40,000/year, maybe don’t start off at the Porsche dealership. If you’ve never owned a home and so far your family is just 2 people, think hard before shopping for houses with square footage in the 5 digit range. Even student loans should be managed with this practicality in mind. A common mistake among 18 year olds applying for their first loan is to take the full amount offered. If it does not take that whole value of what they offer to cover your basic tuition and supplies, do not take it unless it is absolutely vital to your living expenses. There are indeed ways to structure your higher education and loans in a way that does not have to be a lifetime burden, but make no mistake – it takes careful planning and sometimes even personal sacrifice to make it work.
At the end of the day – I hope you’ll take 2 things away from this article:
- If you can’t afford something and it takes an exorbitant interest rate to acquire it (think – TVs, trips, entertainment systems), then think long and hard before you take on that debt and re-read my credit card example above.
- Investing in yourself can be a good thing and if it taking on an appropriate level of debt can accomplish that, don’t be afraid to believe in yourself and take that risk – but also consider asking an advisor for help first to help you evaluate your options.
Debt can either bury you or help take your life to the next level – think before you spend and you will set yourself up with good habits for life!