The Guide to Dealing With Debt (Secret 4)

What it means... How to avoid it... And the only time you should ever use it

At some rudimentary level, we all understand that debt is dangerous. But in our daily lives, many of us view it as a necessity. We buy homes with it. And cars. And boats and electronic "toys" and vacations.  Debt may be useful, but it is not necessary. It is a luxury.  I had my first serious run-in with debt many years ago. My wife and I were renting a condominium flat in Washington, D.C. Our landlady came to us with an exciting opportunity: We could buy the flat for $60,000 (around Rs 36 lacs) with no down payment. For just $100 (Rs 6,500) per month more than what we were already paying for rent, we would be "homeowners." It sounded like a great deal, so we took it.  I was too foolish then to ask myself, "What is the cost of this debt?" What we wound up with was anegatively amortizing mortgage with a three-year term and an 11% interest rate. That meant that every three years we were paying $19,800 in debt service and another $3,000 in closing costs.  [A regular amortizing loan pays itself off over the term of the loan. For example, if you have a 30-year fixed mortgage, after 30 years your principal and interest payments would pay off your loan. A negatively amortizing mortgage creates a payment schedule where your monthly payments do not cover the actual interest costs on your loan. This interest that is not paid is added to the principal balance of the loan. This leads to a situation where your loan balance increases instead of decreases. Negatively amortizing loans are rare if not non-existent now but you still need to be careful and read the fine print on the loans you sign up for to avoid the 'wealth stealers'.]  Eventually, I managed to get us out of that flat and into our first house - but not before figuring out that, even after calculating the rental value of living in the condo, the "deal" had cost me more than $30,000, and I had nothing to show for it.  I learned that when banks make it easy for you to borrow money, it's not because you are a nice, deserving person. I learned that if you can get a loan despite poor credit (as ours was at the time), there is usually a scam involved. It also taught me to always ask the two critical questions about debt: "How much will it cost?" and "Can I afford it?"  It was an expensive lesson. But the lesson seemed cheap 30 years later when, in 2005, the real estate market bubbled out of the pot. I sold my speculative properties and got out of the market. I made and saved millions, while my friends who ignored my warnings got killed.  Let me say it again: Debt is unnecessary, and it is dangerous. It is unnecessary because there are always less expensive ways of getting what you want. And it is dangerous because it can sometimes be very costly.  Let me give you two examples.  Let's say that, like a lot of people, you are in the habit of buying things with credit cards. After a while, you notice that you have accumulated $30,000 (Rs 1,914,300) in credit card debt. You decide to cut up your cards and get rid of that debt. You can devote $400 (Rs 25,524) per month to paying back what you owe. How long will it take, and how much will it cost you?  The answer may surprise you. It will take you 10 years to pay off your credit cards. Your total payments will be $47,428 (Rs 3,026,380). Of that, $13,278 (Rs 847,269) will have been in interest payments.  The commercial community (including bankers and manufacturers) doesn't want you to be afraid of debt. Neither does the government. They want you to like debt. They want you to use it. They want you to go into debt because it is good for them.  When you take out a mortgage or sign a lease on a car or use credit cards to pay for your lifestyle expenses, the commercial community profits. The manufacturers make money on products you may or may not need. And the banks make money on your debt.  The mainstream financial media rarely talk about the dangers of debt. That's because they make their profits from the financial institutions and manufacturers whose advertisements support their publications.  And the government actually encourages us to take on debt.  Here's what you should know about debt...  There are some cases in which debt makes sense. Buying real estate properties is one example. It may also make sense to take on debt to finance a business. But you have to be very careful. You must be sure that the return you are getting on your debt is guaranteed to be considerably higher than the cost of the debt.  In most cases, debt is unnecessary. And it is dangerous. As a general rule, you should live without it.  Unless you have the money, don't get a car on monthly intallments. Buy it outright. Buy the car you can afford, not the car you believe will make you happy. Any non-appreciating asset (such as a car) will never make you happy if you have to pay its debt service. I didn't buy my first luxury car until I was a multimillionaire.  [A non-appreciating asset is an asset that loses value the minute you start using it or take ownership of it. These are things like cars or boats.]  Don't buy anything with a credit card. Use a debit card to buy clothes and groceries. If you don't have enough money in your bank account to use your debit card for a purchase, don't buy it. If you don't have enough money in the bank to buy something, it means you can't afford it.  If you can't afford the debt on your house, sell it (if you can) and buy something cheaper. In any case, start paying off the principal balance on your house (the amount you owe, not the interest you will owe) as fast as you can. Make it a goal to own your house free and clear as soon as possible.  [In this case, the principal is the amount borrowed or the amount still owed on a loan, separate from interest a bank charges you.]  When I started earning decent money, the first thing I did was pay off the mortgage on our home. I loved the idea of owning our home free and clear, so I put every extra dollar I had toward paying down that mortgage. And I'll never forget how great I felt the day I made that final payment.  If you have expensive debt, such as credit card debt, pay that off first. Debt that comes with double-digit interest rates (like credit card debt) is like a big hole in the bottom of your piggy bank. You have to plug that hole before you put another coin in the slot. But if you have less expensive debt, such as a student loan, you might be able to pay it off at the same time as you're putting money into savings and investing.  It's all a matter of math. You need to compare the annual cost of keeping the debt versus the annual return you would get on your savings and investing. You should expect to get, on average, only enough on savings to cover inflation. And you should expect to get something more than 5% and less than 15% on your investing. The logic is this: Give priority to the highest numbers first.  [Inflation is the rate at which the general level of prices for goods and services rise each year. For example, if inflation is 8% the loaf of bread that cost you Rs 10 last year will cost Rs 10.8 this year. Its price went up... and because it went up, you'll end up buying less bread this year.]  Say you have Rs 60,000 in credit card debt with an 18% interest rate and Rs 100,000 in student loan debt with a 4% interest rate. You would pay off the credit card debt first because the 18% on interest you are paying is greater than the 3-4% you get on your savings or even the 5-15% you get on your investments.  After you've paid down the 60,000 in credit card debt (and, hopefully, shredded your credit cards), you are in a very different position. The cost of your student loan debt at 4% is more or less equal to what you can expect to earn from your savings. In theory, it makes no difference what you do at this point. However, in practice, I recommend that you pay off your student loan debt while you save and invest-and take care of all three obligations faithfully.  The main challenge is not arithmetical, however. It is psychological. You must develop what I call a "rich mindset." Someone with a rich mindset has a healthy appreciation for wealth and good financial habits. A person with a rich mindset enjoys saving and investing, just as the person with the "poor mindset" enjoys spending. The person with a rich mindset is uncomfortable with debt, whereas the person with a poor mindset sees debt as something desirable.  If you are troubled by debt, know this: You can get out of it, just as I did. And when you are debt-free, you can begin to use debt strategically. But to do so, you must always ask those two critical questions: How much will it cost? Can I afford it?  If your worry is that you are too old, or that it is too late for you to get on a path of building wealth, then let me tell you that you are not. In fact, my next secret is a message for you. By Mark Ford