Debt has become an American way of life. It truly has. The average American has somewhere around $8,000 in credit card debt alone. Given that the average price for a new car is well over $20,000, many Americans also have car loans. And of course, there is the debt that has caused so much trouble in the financial markets of late: the mortgage, which is debt on a house.
The reality is that Americans spend a lot of money buying stuff. The scary reality is that frequently we cannot afford it, so we go into debt. Being in debt makes it difficult to get rich.
The Danger of Debt
Credit card debt is the most common and most dangerous of all the debts. These are considered unsecured loans, which means that if you stop paying, the bank doesn't have a specific asset that it can take in order to settle the debt. As a result, the interest charges on credit cards tend to be higher than other forms of debt. There can also be outrageous terms and charges associated with the card that sink you even further into debt when you run into trouble.
The interest rate on a credit card is normally 8-15%; it can go as high as 21% or 29.99% if your credit is poor or if you have missed payments. Stores that offer cards specific to them (such as Sears, Lowe's, etc.) tend to have higher rates than normal MasterCard and Visa accounts. The interest rate on many cards can change if you miss a payment or are late with a payment. Some cards include provisions that they can raise your interest rate if you are late on any debt payment, not just one to them.
The card companies also try to string out your payments by allowing you to make a minimum payment that is well below what you owe in total. Giving in to the temptation to pay the minimum (or near the minimum) is a sure-fire way to waste your money. Depending on your interest rate and terms, it could take you up to 21 years to pay off a credit card if you make just the minimum payments. During that time, you will pay THOUSANDS of dollars in interest to the banks.
Add on top of this some of the crazy fees, such as late payment or exceeding your credit limit, and the total you shell out increases even more. Think of what you actually buy on the credit card... chances are that it is nothing substantial. You might buy clothes, or gas, or even groceries. But if you fail to pay off the full amount, you have to send more of your money to the bank for failing to do so. That means you are paying interest on your clothes, gas or groceries.
Because credit cards are so easy to use, yet more difficult to control and track, they frequently are the source of financial problems as people become overwhelmed trying to pay all of their minimum payments, plus pay for essentials like electricity, water and the house.
Bad Debt
Bad debt is debt taken out on an item that does not increase in value. Credit cards top the list. Auto loans are a close second. For example, a 2009 Chevrolet Impala LTZ has a Kelly Blue Book value of around $29,000. The 2008 LTZ with 10,000 miles is worth about $19,000. So one year of use has knocked off about 1/3 of the value! The same math holds for a Ford F150 SuperCrew cab. The 2008 version, new, is about $32,000 for the XLT. A loaded 2007 with 10,000 miles sells for around $21,000.
For certain vehicles, the one-year drop is not as dramatic, but you can still bank on losing at least $4,000 the moment you drive a new car off the lot. Given this poor record, why would you want to pay interest on a car or truck?
Buying a used car that you can afford helps keep more of your money in your pockets. Even if you are a "car guy" (or "car gal") and take impeccable care of the vehicle, it will never be worth what you paid for it. The reality is that a car (or truck) is a tool for transportation. It will lose value because you use it in the manner it is supposed to be used. Taking out a car loan ensures that you send lots of money to the bank for something that will be worth about one-half to one-fourth of what you paid by the time you own it in full.
I know for a lot of police officers, the idea of not having nice cars and other toys sounds like heresy but if you take out loans to pay for them, you are condemning yourself with bad debt.
Good Debt
There is only one good debt: the home mortgage. Despite the collapse in the housing markets, the reality is that owning a home is generally a good investment for most Americans. There are a few keys to making home ownership smart.
First, buy a house you can afford. This may sound simple, but too often, people end up house rich and cash poor. This is a tough way to go through life. Avoid the temptation to buy more house than you need. Really, how many bedrooms and bathrooms can you use? Yes, you should be comfortable. Yes, you should be safe. But does your family really need a 5,000 square foot house with a walk-out basement and three-car garage?
Second, save and plan for the house. When you buy a house, remember that you will have a ton of other expenses. New furniture, new curtains and blinds, moving expenses, maybe new appliances or carpet - all of these take lots of money. Don't spend everything on the house; leave a cushion so that you can take care of these requirements as well.
Third, get a fixed-rate loan for 80% of the value. Fixed-rate loans do not change, and despite all the turmoil in the market, the rates are still near historic lows. This makes it easier to budget your housing expenses and you don't have to worry about the payment adjusting in three or five years. The 80% figure is magic because you can avoid Private Mortgage Insurance, or PMI. Banks make you purchase an insurance coverage for them that helps protect them in case you run into trouble paying. Banks figure if you have invested in 20% of the home's value with your own cash, you are very unlikely to have a foreclosure. I have read some articles recently indicating that some banks will not even consider a mortgage unless you have a 20% down-payment.
Last, don't take out other loans on the house. Home-equity loans, which used to be called second mortgages, were quite the rage. People used the loans to pay off their other bad debts. But, they placed their houses at risk if they didn't change the spending patterns that created the bad debts. Let your house payment be your house payment; don't burden it with more debt so that you can take a vacation or buy a big screen TV. Do you really want to risk your house over that if you fall behind on payments?
Conclusion
Credit cards and other bad debts are giant leeches on your income. Banks will gladly suck as much money out of you as they can, but they can only do it with your permission. Stop giving them permission to take your money. Avoid credit cards, stop buying toys and cars on loans, and stay in a house you can afford.
The reason for all of this is that if you stop sending extra money to the banks, you might have extra money to invest for your own retirement. And in 25 years, that shiny new vehicle will be gone, but how and where you retire will be on the horizon. Spending wisely now means you can retire more comfortably down the road.
Then you'll be able to pay cash for whatever toys you want for retirement!
