Not All Debt is Created Equal
Eric Udvari, CFP®, Wealth Manager
Hi, my name is Eric Udvari, CFP® and Wealth Manager at Howe and Rusling. Today I’m going to discuss debt. This is a topic of conversation that we have all the time with our clients. The first point that I would like to make is that not all debt is created equal. Debt can be good, and it can be bad.
And when it comes to good debt a few examples include real estate, owning your own business and education. Owning your own home traditionally looks like borrowing funds at a lower interest rate to buy an asset that will likely appreciate over the course of a couple decades. Along the way you get to enjoy the house and a few tax breaks as well. Taking on debt to start your own business can also be another good form of debt. Being an entrepreneur and starting your own business has its risk but can also be a fulfilling way to fill your time. Finally, investing in your education is great way to get a leg up in the workforce, but make sure that the money you are spending on your education will make you marketable.
Bad forms of debt can include consumer debt—specifically credit card debt and auto loans. Credit card debt is some of the highest interest-bearing debt for consumers and if not managed correctly can take months or years to pay off. If you use a credit card, which in and of itself is not bad, make sure to pay off your balance in full at the end of the month. If you know you can’t control yourself, just stick to cash and debit cards that don’t allow you to spend beyond your meas. Using a debt card or cash tends to make you think twice about those frivolous purchases. And here’s a tip: before you hit the purchase button on Amazon, leave it in the shopping cart for a day or two. If you still must have it after a couple days, simply make sure you’re staying within your budget.
Cars, on the other hand, are a necessity for many people, but when it comes to taking on an auto loan, it’s important to understand that your car immediately loses value once you drive it off the lot. This is called a depreciating asset. You’ll end up spending more on the car over the life of the auto loan, and yet the car will never be worth the same amount compared to the day you drove it off the lot. If you don’t have enough cash on hand to buy the car outright (many don’t in this current market) try to obtain a 0% loan or a loan with the lowest possible interest rate. Having a good credit score helps in the scenario. Many fall into the trap of solving for a specific monthly payment for our auto loan, but anytime we increase the term of the loan, say from 60 months to 72 months, we are just paying the lender more interest.
For those of you who already have debt, all is not lost. We just need to implement a game plan for paying off that debt. I encourage you to start with a list of all the debt that you currently have. Figure out your payments, the length of the loans, balances and minimum monthly payments. From there, review your monthly budget. What does your extra income look like each month? If you tend to spend everything you make, we can look for areas that we can trim back on. Finally, pick a repayment strategy.
Now, repayment strategies come in 3 different flavors:
1. The snowball method
2. The debt avalanche method
3. Debt consolidation
The snowball method starts with paying off the smallest balance first and paying the minimums on the rest. Once that small balance is paid off, you take that amount you were contributing to the now paid off debt, and pay it toward the next largest debt. This process continues until you are debt free. This is a great way to gain confidence and pick up some easy psychological wins. Now this strategy may not be perfect if your highest balance is on a high interest bearing credit card. Therefore, it is important to first understand how all of the debt is structured.
The debt avalanche method starts by paying off the largest balance or highest interest debt as quickly as possible, while continuing to pay minimums on the rest. After that balance is paid off, move to the next smallest det. Psychologically, paying off a big debt can give a huge boost of confidene, but this can take longer to get the first win under your belt. Patience is key with this method.
Finally, we have debt consolidation. This is where you take multiple debts and combine them into a single account. This is a great way to make one payment and stay organized. It can also allow you to lower the interest rate on the debt. During this process, many people take their existing credit card debt and transfer this to the new account. Seeing a zero-balance credit card is a huge win but keeping it at zero is another story. I have seen too many people consolidate debt, just to rack up the balance on their credit cards again. This is how you can get yourself into some serious trouble.
Hopefully you can see that debt is a topic full of nuance, but there are very simple rules to understand and follow to gain or keep a healthy relationship with debt. After all, it’s a powerful tool if used responsibly. If you would like to discuss this topic further, we welcome a friendly conversation. Thanks for tuning in to Street$marts!
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