Frugal Fridays: Bad Debt and Good Debt
Fri May 18, 2007 at 01:25:34 PM PDT
Welcome to "Frugal Fridays" where we share money saving tips, discuss living frugally and generally talk about personal finance issues. I keep reading about how Americans are carrying a higher debt load than ever before. There are many possible causes of this that are outside an individual's control (everything from predatory credit card issuers to the fact that housing is more expensive relative to individual income than ever before in our history) and some that are definitely within every individual's control. While most discussions start from the premise that being in debt is a bad thing, I think that may be a false assumption. There are some aspects of debt that can be positive and some loans can be downright advantageous to the borrower. The key is to figure out what kind of debt you have and jettison the bad, while keeping the great.
Bad Debt
The most common type of what I call "bad debt" is a loan where whatever it is that was bought with that loan is now worth less than is due on the loan. Credit card debt is the most obvious example of this kind of debt, but store loans, some car loans and even some home mortgages can fall into this category. This kind of debt is to be avoided at all costs. If you are currently carrying any debt like this, you need to make it a priority to pay this off (see below).
Good Debt
Good debt is debt that one has to take on to buy something that appreciates in value. If the alternative to taking on this debt is to not buy this thing that will improve your life financially and/or spiritually, it is worth it to take it on. However, depending on the interest rate, you probably still want to try to pay off this debt as soon as possible. The most obvious example of this type of loan is a home mortgage, and some car loans, but I also include student loans in this category in most cases.
Although a college degree may not necessarily lead to enough of an increase in wage earning capacity to make it a winning decision in the financial sense, the amount of increased earning you can get from a job with that degree is not the only measure of its value. Sometimes that degree can lead to a happier or more fulfilled life. Unfortunately, an education is one of those things that you have to purchase before you know what the true value will be to you. Some people really regret going to school and incurring large student loans that weigh them down for years, and some people don't. kath25's diary last night on Graduate School is a great place to start looking for advice if you are trying to decide if graduate school is right for you.
Note that I would only categorize these types of loans as "good" as long as the interest rate you are paying is higher than the current return you could get on your investments. If you are paying significantly less than that, what you have is not "good debt" but "great debt"!
Great Debt
Great debt is debt you should seek out whenever possible and use it to your advantage. This is debt where the interest rate is extremely low (or zero) for some period of time. The key to remember is that lenders are not offering these loans out of the goodness of their hearts. They are offering them to you because they think you are too stupid to pay off the loan before the advantageous period expires, because when it does expire, WHAM, they hit you with a huge penalty. You may have to be careful and keep on track of deadlines, but you can save a lot by getting loans like this sometimes. Great debt can include:
- Interest Deferred Student Loans These include the federal student loans as well as some loans offered by private universities. Make sure that the interest truly does not accumulate while you are in school. My contention is that even if you don't need to take out these loans to pay for school, because you have enough savings or other sources of income, it's a wise decision to take them out and save or invest your other income. Since the loans accumulate no interest while you are in school, all the interest you gain on your savings is free money. At the end of your schooling, you can use your savings to pay off the loans and keep the interest you earned for yourself.
- Credit Cards I know I said that credit card debt is bad debt, but that is only true if you are carrying a balance. If you pay your balance off in full every billing cycle, you have made the credit card company pay immediately for your purchase, while you get an interest free loan for a few weeks. When you add in the fact that you are getting increased security and convenience (it's hard to send cash over the internet) when you use a credit card, the deal is even better! But wait, there's more! You also get a free record of your purchase, so you can track and budget your expenses! And better yet, you can even get the credit card company to pay you for the privilege of lending you money. You may only make about 1% of your money back, but that is totally free money. It makes me cackle out loud every time I think about it. (And I wonder why people edge away from me in public.)
- Balance Transfer Offers If you are trying to pay off high interest debt, you may get offers for low interest balance transfer loans. Keep in mind that the low interest offer is usually only for a few months and then the interest rate will skyrocket again. However, a few months of low interest may be better than you have now. In addition, you may be able to take advantage of a new offer in a few months and transfer the balance again. Be sure to not use that credit card for any new purchases. New purchases will be subject to a different (higher) interest rate and be assured that the credit card company will apply your payments to the balance that benefits them the most, not you. Here's a site that might help you find the best offer for you.
- No Interest or Payments Til Next Year Often stores will run a sales promotion where they offer you a certain period of time where you don't have to make payments. Before you accept this offer, first make sure this is something you wanted to buy anyhow. Next make sure that interest does not accrue in this grace period. Finally, before you go into this deal, make sure that you have the means and the ability to pay the loan off in full before the grace period expires. If you don't already have the money in the bank, or know for certain that you will at that time, don't start down this road.
- Low Interest Home Mortgages Home mortgage rates are climbing now, but they still may be lower than the rate you are currently paying. If they are, you should look at refinancing to a lower rate. If you know for certain that you will be selling your house in a few years, you may want to look at a variable rate that remains fixed for 5 or 7 years and then varies. Otherwise, I would suggest only looking at fixed rate mortgages. You never know what will happen to interest rates and those of us that lived through the 70's (when loans of 10, 12 and 14% interest were common) are mighty skittish about subjecting ourselves to the vagaries of variable rate mortgages. Keep in mind that there will be associated costs with refinancing, but run the numbers and see if it makes sense for you. Here's a nifty calculator that might help.
- Investment Loans (Real Estate, Stocks, etc.) This is the least secure type of "great debt" to enter into. If, for example, you are certain that the real estate market in your area will continue to increase at a double digit rate, it makes perfect sense to take out a loan to buy an investment property that you can flip in the short term for huge profit. But the fact of the matter is there is no such thing as a sure deal in any investment market, as the folks in Las Vegas are learning now. You can go this route, but you are taking a risk, so be sure and do a lot of research before you start down this path and don't risk anything you can't afford to lose. During the height of the stock market bubble, I heard of people taking out second mortgages on their houses to invest in the market. To me that was a crazy idea, if they lost it when the bubble popped, and the housing market dipped even a bit, they could be in danger of losing their house.
Getting Rid of Debt
Every time I start looking at advice or suggestions for getting out of debt, I am struck by how similar the language is to diet and exercise advice. Almost every persuasive argument in favor of (or obstacle in the path of achieving) your goal in one situation has a direct analog in the other. I say this as someone who has been really struggling (with very little success, I might add) for years to lose weight and yet as someone who has only ever carried what I call "great debt" in my life. How can I be so good at one of these tasks and so sucky at another? I don't know, but it does give me more sympathy for those folks trying to get out of debt. The main thing I can offer is this takes a concerted investment of time and energy and effort. You will need to change your lifestyle and give up things you really enjoy. If you need some motivation, try picturing what your life will be in five to ten years if you don't change your habits. You will be even deeper in debt, and will have less time to remedy the situation before you reach a point where you can't work. Here's my advice on how to get started:
- Honestly Assess Your Situation
Take a good long look at your financial situation. Sit down with all your bills, your bank statements, your paycheck stubs and make a list of all your obligations. You can do this the old-school way with just a pencil and paper, but there are free spreadsheet programs out there (e.g, Open Office, or Google Documents) so there is no need to make it even more difficult for yourself. Make a spreadsheet showing each lender, the interest rate and the amount owed. Make another sheet showing your monthly budget. List everything you spent money on in the last 12 months. List all your monthly expenses (rent, food, utilities, phone, gas, entertainment, clothes, haircuts, etc.) and list expenses that don't come up every month (car registration, insurance, property tax, medical, etc.) Don't forget your tax obligation. Just because it is automatically deducted from your paycheck doesn't mean it's not an expense you are paying. If you have a category called "cash" and you don't know where you spent that, you need to figure that out. For a month, carry around a little book or PDA and every time you spend cash, write it down.
- Make a Plan
There are some great calculators on the web to help you figure out how long it will take to pay down a given debt. This site has so many different ones, you should be able to find one to help you. Be realistic in your savings goals. Depending on the seriousness of your situation, just cutting down on your spending by giving up things you won't miss that much may free up enough in your budget to make a difference. In more dire circumstances you may have to start looking for a second job or other ways to increase your income, at least in the short term. Remember your goal is to completely eliminate your credit card debts. You want to get to a point where all of your credit cards are paid in full every month and you are carrying no other consumer debt (stores, car loans etc.).
- Change Your Lifestyle
This is the hardest step. It's where the rubber meets the road. For specific tips on how to save money, you can check out previous Frugal Friday diaries or pick up (from the library, of course) a how to book like Smart Women Finish Rich by David Bach or The Money Book for the Young, Fabulous & Broke by Suze Orman. You will probably want to cut up most or all of your credit cards. You may want to look into loan consolidation but be very careful before engaging any kind of credit counseling agency. Some of these places are designed to take advantage of desperate people and you can end up in a worse financial situation than you started.
- Enlist a Support Network
It's so much easier to tackle a seemingly insurmountable problem if you have your own cheering section to boost your spirits when you get discouraged. If you can't approach friends and family with this, for whatever reason, don't worry, you are in the age of the internet. There is a whole community of "debt bloggers" who are blogging about their attempts to get out of debt. They get helpful suggestions and positive reinforcement anonymously. Here are a few I've come across:
Picking and Using Credit Cards Wisely
I had originally planned this as the topic of the diary, but as I started investigating this topic more, I realized that a lot of people are not yet at the point where they can use credit cards to their advantage, because they are already carrying large balances. Hence my diversion above.
Once you have eliminated all your "bad debt" it's time to start using credit cards as "great debt". If you don't think you can be trusted to only charge what you can pay for immediately, then you may want to use a debit card instead. Be aware that debit cards offer much less theft protection than credit cards. If a thief steals your card and wipes out your account, you may eventually get the money back, but you have lost the use of that money while you are fighting with the bank. My advice would be to open a separate bank account for that debit card; only put in that account the amount of money you are comfortable spending; and make sure that account is not linked by "overdraft protection" to your main account. There are some web sites out there to help you find the credit card that best suits your needs. Here are some things to consider.
- Pick a card with a great rewards program and little or no annual fee. Since you are always going to pay this card off, you don't care what the interest rate is. If there is a rewards program that is particularly valuable to you it may be worth paying a low annual fee to get it. Discover cash back program is pretty good, and they even have a deal where instead of taking cash, you can get gift cards for a greater amount. For example, I can get $20 in cash or a $25 gift card to Borders.
- If you are going to use the card abroad, look at what cards are accepted where you are traveling (for example, Discover card is not accepted in Europe) and look at what fees they charge for purchases in foreign currency (most charge 1 to 3%, but shop around and you can find some that don't charge any fee).
- Look for a card with a long grace period (the number of days from the statement date to when you must pay the bill to avoid finance charges).
- Set up automatic payments. Make sure you have a good system set up so that you always get your bill paid before the grace period expires. If you do miss a payment, and finance charges start accruing, go on-line, check your current balance, and pay that entire amount (send the check for a little extra, to account for any interest before the payment is posted). You need to drive the balance to zero to stop the interest charges from accruing.
- Make sure they have on-line services. The most important service they should offer is the ability to generate one-time use numbers that can be used when shopping on-line. This way you can help reduce the possibility of identity theft by not sending your real credit information over the internet. The second thing I would look for is the ability to pay your bil on-line. More than once I have needed to use this service when I forgot to pay my bill until the last minute. The ability to monitor your spending real time is also a great benefit.
Update [2007-5-18 16:30:51 by sarahnity]: ARRGH! I just realized it went out with the wrong title. I wonder how long it will take this to update.
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