Debt is expensive.
That’s me stating the obvious, and you’re welcome for that. What we don’t often think about are the mechanics of taking on debt before we do so. When we take on debt we are essentially taking possession of goods or services before we have paid for them, and we have to pay a lender finance charges in order to do so. This is true of any debt, but by taking on credit card debt you are essentially paying a high interest loan in order to finance your everyday spending. You are spending money that doesn’t belong to you yet, and you are also using money you have not yet earned to pay any future interest payments.
Let’s look at a few examples:
- The average home is priced at $188,900. With a 30 year mortgage and an average credit score you can get a 4.974% interest rate. After that 30 years is over, you will have paid $363,980.35 for that house. In addition to the price of the house, you will have paid a total of $175,080.35 in finance charges. Now you can see why I think it is silly to sell your house every five years or so to make a “profit”. You might be making a profit on the list price, but you certainly are not making a profit compared to the total paid. You are also then moving into a new home and subjecting yourself to a fresh round of finance charges without having received any benefit from the finance charges paid for your previous home.
- The average new car costs $31,252. Those with average credit qualify for an interest rate of 6.746% on the average 60 month loan. This means that this new car costs a total of $36,905.32 to own. You end up paying an additional $5,653.32 in finance charges above and beyond the market price of the car.
- The average consumer has $15,611 in credit card debt and has an average credit card interest rate of 15.68%. This provides us with a minimum payment of $624.44 per month, and it would take us 167 months (almost 14 years) to pay that balance off if we kept with the minimum payment schedule. In the end we would have paid a total of $23,084.72 to the credit card company. That is $7,473.74 paid just for the luxury of taking out a high interest loan to pay for our overages in everyday spending. I’m guessing that 14 years later it is likely you wouldn’t even remember what you originally spent that $15,611 on.
Learning More About Your Debt
Now it is time for you to inventory your own debt. You can do so using the Debt Repayment Plan workbook. In this workbook you will itemize all of your debts including the lender, loan type, current balance, interest rate, and the number of years it will take you to pay that debt.
Now that you have a good overview of your debt, you can do the following:
List your debts in order of highest interest rate to lowest interest rate. It is likely that your highest interest rates will be credit cards, personal loans, and, perhaps, subprime car loans.
Try to reduce your interest rates to the lowest amount possible. Stay tuned tomorrow when I review a script you can use to get lower interest rates from your credit card companies. Even a modest reduction in your interest rate will have a big impact on the total amount you pay for your debts over time.
Pay off all of your high interest debt. I’m sometimes asked if it is better to pay off debt more quickly or save your money. When it comes to high interest debt, it is best to pay the debt first. This is because you will be losing money in interest charges faster than you can earn interest by saving. Pay off your high interest debts, including credit cards, personal loans, and subprime car loans, in the order of highest interest rate to lowest interest rate ensuring that you are paying the minimum due on all debts each month.
Do not, I repeat, do not take on more debt. During the time period when you are paying off your high interest debt do not add to your burden by taking on more debt.
Create your safety net fund. Now that you have paid off your high interest debt, you can build your safety net fund. You can check out “Finding Financial Freedom with an Emergency Fund” for more details.
Consider paying down other debts. Later on down the line, once you have created your emergency fund and set up your plan to invest in your future, you could consider paying down your other debts, like your mortgage, car loans, and student loans. Paying down your debt even a modest amount will have a big impact on the interest charges you pay down the line. The ultimate goal here is not to become completely debt free but to live your life at the lowest cost possible.
Do You Really Need This Now?
Remember, we go into debt when we take possession of goods and services before we pay for them. As a result, before you take out a loan for anything, be it a home or a box of Kleenex, you should always ask yourself whether or not you need to take possession of a certain item now. The alternative is saving up the money first and then purchasing that item interest free. Using our examples above
- If you simply waited to purchase items, or decided not to purchase them at all, instead of putting them on a credit card, then you would save $7,473.74 in credit card debts
- If you held on to your current car a few years longer, and saved for your new car over time, then you would save $5,653.32 from not getting a car loan. If you must take out a car loan, then Suze Orman’s advice is that if you can’t afford to pay the loan off in three years, then you cannot afford that particular car.
- In the most extreme example, you can save $175,080.35 by buying a house in cash. Few of us can do that, but we could save almost $100,000 in finance charges by taking out a 15 year loan instead of a 30 year loan.
For all of these reasons, you should always ask yourself, “Do I really need this now?” before taking on debt.