Debt is a very touchy subject. Some people think there is such a thing as “good” debt. Then there are others who mistakenly think they will become wealthy by hanging onto their 3% loan as long as possible. And still others can’t tell the difference between being able to afford a car vs being able to afford the car payments.
We are all good at rationalizing why it would be acceptable to go into debt so we can enjoy that new boat/car/motorhome that we could otherwise not afford to purchase. Yet, we totally miss the point of the last part of that sentence, which is, we can’t afford to purchase it right now. If we can’t afford it, we shouldn’t buy it until we have saved enough money to purchase it with cash.
Managing debt is not something we should ever strive to be good at. Eliminating debt is the better alternative that leads to a much nicer, less stressful life with a lot more money in the bank.
People will uproot their families and move across the country to get a $2,000 a month raise. But you can get that same raise in monthly spendable income by paying off your debt without having to get another job and move. When taking taxes into consideration, paying off enough debt to eliminate $1,200 a month of payments is about the same as getting a $2,000 a month raise in salary.
There are very few times when debt is a reasonable option. The rest of the time it should be avoided. Let’s look at the most common debts that strap us down with an unnecessary financial burden.
Credit Card Debt
There is no reason for this debt to be a part of our lives. The prudent family spends less than they earn and saves the rest. The only reason credit card debt accumulates is because our spending exceeded our earnings, and the credit card loan was required to make up the difference.
I have a great opportunity to investigate the personal finances of many people when they go through my Total Financial Makeover program. I often find high income earners with credit card debt. When I ask them what created their credit card debt, they almost always can tell me exactly what happened to create the unpaid credit card balance. In their eyes, it’s always a “very good reason.”
I can usually point out the money they have in their savings account is earning 1% interest, while the bank who issued the credit card charges 23% interest. They put money into the bank (saving account) then they turn around and borrow money from the bank (credit card) and the bank earns 22% (23% – 1%) interest in the process. When put like that, it sounds silly. Because it is.
One of the first moves my clients make is to pay off their credit cards and never carry an unpaid balance again. Making this one move saves their family 22% interest. Not many options exist for someone to get that kind of guaranteed return.
Automobile debt
Americans are obsessed with having nice cars. But many of us will never actually own a car. We will acquire a car with a six-year loan and in 2-3 years we trade it in and acquire a new six-year loan for the new car. If this process repeats itself for our entire life, we will never own a car.
What if we rephrase this situation. Would it be a good idea to rent a car for your entire life? Almost no one would think that is a good idea. Yet that is exactly the scenario I portrayed. It is also the same as perpetually leasing a vehicle. Never owning is an expensive way to drive a car.
Another problem when dealing with automobiles is the mistaken belief that being able to afford the car payment is the same as being able to afford the car. The car we can afford is the car we can pay for with a personal check. Let’s stop buying cars we can’t afford simply because the dealer will let us borrow money to do so.
Buy a car with cash and drive it for at least ten years. Then trade it in and get another one with cash. This is done by saving money for a car purchase before buying the car. A fallacy that many believe is that acquiring a business car on credit or with a lease will yield a better tax write off. That is a falsehood perpetuated by the people who make a fortune off those perpetually leasing their cars or paying interest.
Student loans
Student loans are one of three reasonable debts to take on. (The other two are our first home mortgage and an income producing investment property.) Just because we choose to finance our education with student loans doesn’t mean we should stretch out paying the money back, giving the bank a bunch of extra interest payments. They don’t deserve our hard-earned cash as much as we do.
When I finished my residency, I had less than $6,000 of student loans remaining. I started my attending job and had a big jump in pay. My wife wanted to pay off this last student loan and be done. I disagreed with her, because we were only paying 3% interest on that borrowed money, it was a “great” loan. (The fallacy that there is such a thing as “good” debt had me thinking I wanted more of this debt in my life.) Instead of paying back the loan in its entirety, we could invest the $6,000 and make 10% in the stock market.
She then pointed out that I was holding on to this loan and making her write a check every month to make a maximum of $420 a year in interest rate arbitrage, before taxes (assuming we actually invested the $6,000). After taxes we would have made about $260 the first year and that would decrease every year as we paid down the loan. How much do I have to work to make an extra $260 next year? Was it really worth her time to write a check every month and buy an envelope and stamp to maybe make $260 a year?
Who was I kidding? I was not going to become wealthy by playing the interest rate arbitrage game. I borrowed that money with the notion the bank would help me pay for my schooling and when I was earning the big bucks from my job, I would pay them back. There is no reason to stretch out these payments. Plan to pay off your loans within five years of becoming an attending. The only exception to this is if you are in a job where you can us the PSLF program. By the way, we paid off the loan and I felt a weight lift off my shoulders that I didn’t know existed. Debt takes a toll on us we don’t even know about.
Home Mortgages
The home mortgage is another misunderstood loan. A 30-year mortgage is one method banks use to transfer the maximum amount of money from our wallet to theirs. At the start of this loan, almost all of our house payment is going towards paying interest, also known as pure profit for the bank.
Buy a house with a 15-year mortgage and you will not only save 15 years of payments, the bank will give you a lower interest rate as well. Then, pay it off ahead of schedule. We paid off our house in four years and have not had a house payment since.
Your personal residence is not an investment, it is an expense. Don’t fall for the idea of buying the most expensive house you can afford. That is exactly how people become “house poor.” Thinking we will use a 30-year mortgage to provide more “flexibility” in the budget is also not good logic. There is not much difference between the payments of a 15-year and a 30-year mortgage. If something happens that would make it difficult to make the 15-year mortgage payment, it is likely the 30-year one will be hard to pay also.
Lastly, don’t fall for the “mortgage interest being deductible” tale. If you are taking the standard deduction on your taxes, you are getting no tax write off for your mortgage interest. Mortgage lenders stress the ability to write off the mortgage interest, but 90% of taxpayers take the standard deduction and therefore get no write off for their mortgage interest. And if you are one of the 10% who do itemize, the first $29,200 is not a write off. Only the amount that is itemized above the $29,200 standard deduction threshold will be a benefit on your taxes. That makes the home mortgage write off way less valuable if you even get to use it.
Buy a reasonable house that will meet your needs with a 15-year mortgage, located within 15 minutes of your work, so you don’t waste your life commuting. Then pay it off quickly and you will never need a home mortgage again. If you move, the money from selling your paid off house can be used to buy the next house with cash.
Paying off your house has two great advantages. Your cash flow will jump considerably when the house payment is now going into your savings account instead of to the banker. The monthly increase in our cash flow after paying off our house was enough to pay for the college expenses as they occurred for our two kids, without using any savings. The other advantage paying off your house brings is it lowers your monthly expenses. With the home mortgage eliminated, you will need to save considerably less money before you can retire. Using the 4% rule, removing a $4,000 a month house payment from your retirement expenses means you will need to save $1,200,000 less in your retirement savings accounts. Just think how much sooner you will be able to retire if you don’t have a mortgage.
It’s time we all stop trying to manage our debt and start eliminating it. Live like the wealthy who don’t buy stuff with borrowed money. If you want more information about how to eliminate debt, read my book The Doctors Guide to Eliminating Debt. Debt free is truly free indeed.
