It’s so easy to start, often impossible to stop. The first time I was offered a credit card was my freshman at Texas Lutheran University. In the bottom of my book bag were offers for not one, but two “guaranteed approval” credit cards.
Seriously, what were these people thinking? I’m 18, with no income or opportunity for repayment. The issuers of credit continue to be more and more aggressive, knowing the earlier they get you hooked, the more you’ll be a repeat user. In the process, you slowly become numb to the implications.
For myself, and millions of others, this is how it starts. It is so easy at first and then you wake up one day with an overwhelming mountain of debt and little hope of digging out.
Over the last fifty years, credit has been extended with increasingly loose standards and terms. Left unchecked, it is the equivalent of financial cancer, slowly eating away at your net worth from the inside out.
How do you deal with it?
First, recognize that incurring debt is an investment decision. It is not necessarily good or bad, but rather depends upon how you use it. In assessing this, you must think through the “opportunity cost.”
If I borrow money at 25% interest to buy an ordinary pair of shoes, it is probably a bad decision. That should be common sense. Conversely, borrowing money at 4% to buy a house may not be so bad.
In evaluating things of this nature, we ask our clients what the cost is, beginning with the interest rate. Then we address whether it is tax-deductible in nature. Usually a home mortgage or home equity loan is tax-deductible. Tax deductibility is not a reason to borrow money. You are still paying out more in interest than deduction you receive, but it can reduce the cost.
If a client is in the 25% marginal tax bracket with a home mortgage at 4%, their net cost of borrowing is closer to 3%. That is a fairly low hurdle rate for the home investment—plus, you need a place to live.
However, if borrowing money for a car or on a credit card, it is not income tax deductible. If you carry a balance on a credit card at 25% interest, and you’re in the 20% marginal tax bracket, your true “breakeven” from an investment perspective is more than 30%. That is a very high hurdle rate.
If you invert the discussion, ask yourself this: “Would you accept an investment guaranteeing a pre-tax return of 30%?” Of course, you would. That is why the credit card companies do it. Borrowing money on credit cards is the financial equivalent of heroin…it may be fun at first, but it will eventually kill you.
Often, younger people coming out of college have student loan debt, car debt, a credit card balance and maybe even a home mortgage. When working with a client with multiple forms of debt we help them assess which ones to pay down first.
We start by developing a spreadsheet that lists the amount owed, the monthly payment, the interest rate and the remaining number of payments. We will also determine if it is tax-deductible debt or not.
It should reasonable that tackling the one with the highest interest rate often makes sense. However, occasionally, we will attack debt with a lower rate first.
Although counter intuitive, we look at the remaining balance and the monthly payment. For instance, we may have a car note at 5% interest, a monthly payment of $250 and a payoff value of $3,000. If we have enough cash sitting in savings, we may decide to pay off the car entirely.
Not only does this save 5% interest, but it also frees up $250 a month in cash flow. Once this is accomplished, the increase in cash flow can then be redirected to the higher interest debt. This is as much a matter of freeing up cash flow as it is strategic debt repayment.
In the end, debt management is as much about disciple as anything. Differentiate between needs and wants and recognize there is a cost to all decisions. Some of the largest failures in society come from debt mismanagement. Be frugal and disciplined, always remembering to pay yourself first.