Poisonous Debt


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There is probably no good debt, although some people may debate and say that a home mortgage is a good debt because it allows you to stop paying money to rent and helps build your credit.  Still, even with a home mortgage, it is usually better to pay the debt off than it is to hold onto a home mortgage.  Doing so allows you to stop paying interest on the loan, which means more money in your pocket for saving and investing.  It also reduces your risk since all you need to then do to keep your home is keep paying the property taxes.  If you lose your job, all you need to do is pull together maybe a couple of thousand dollars per year and you won’t need to worry about keeping a roof over your head.

Still, mortgage debt isn’t what I would call poisonous debt – debt that is very difficult to control and that will tend to grow with time unless you are very diligent.  That kind of debt has the following characteristics:

1.  It has a high interest rate.  Take 72 and divide by the interest rate.  That simple calculation will tell you how many years it would take a debt to double if left alone.  If you have a 4% home loan, it will take a little less than 20 years to double, meaning that you will pay about twice the loan amount for your home by the time you pay off a 30-year mortgage.    For a 20% interest credit card, it will double about every three and a half years.  Take three years to pay off something you buy on a credit card, and you’ll pay double.  How’s that $14 latte taste?

High interest makes a debt poisonous because you end up paying a lot of interest each month, so the total amount of the debt rarely goes down.  For example, if you owe $10,000 on a credit card at 20% interest, the first $167 you pay just goes towards paying down the interest.  Pay $250 and you’ll only knock the balance down by about $83.  If you make $30 per hour after taxes, that means you’re working the better part of a day per month just to pay the interest on your credit cards!

2.  It is for something that goes down in value.  If you take out a loan to buy something that goes up in value like a home, the increase in the value over time will reduce the amount you actually pay for the item.  This, in addition to the effects of inflation, help you get rid of the debt.  Plus, when you’re done you have something for all of the money you’ve paid.  Buy something like a car on credit, however, and you may very well owe more on the car than it’s worth during most of the time that you have the loan.  By the time you finally pay off the loan and own the car, it may be time to buy another one if you take out a 6-year loan.  At the end of the car loan, all of the money you paid is just gone.

3.  It has a variable interest rate.  You must remember that the lender is in control when you have a loan.  The only thing worse than owing money is owing money where the lender can change the terms on you.  You don’t want a loan like a variable rate home loan or a credit card where the payments may rise to the point where you cannot afford to make them.  You also don’t want your lender to be able to raise rates until you’re stuck in debt forever.

So, based on these criteria, what are the poison loans that you should pay off first, or never get into in the first place?  Here are different types of debt listed from worst to best:

Poison Debt:

  1.  Payday loans:  Both have high interest rates and are generally for something that goes down in value.
  2. Credit cards:  Credit cards have high interest rates and often variable rates.  Plus, be late for a payment and you could see your interest rate go up to 35% or more.
  3. Margin Interest:  This is interest charged by a brokerage firm for buying securities beyond your means.  The danger here is that you may be forced to lock in a loss should your investments go against you.  Plus, the interest rates aren’t all that good.

Draining Debt:

  1. Car Loans:  If you need a loan to buy a car, it means that you are buying more car than you can afford.  Instead, save for a few months and buy a $3,000 car for cash from a private owner.  Drive that for a year or two, saving payments all of the time, then trade up for a $8,000 car.  Then, either continue to trade up or just be happy with $8,000 cars (they aren’t bad at all).
  2. Student Loans:  If you can get through college without student loans, do so.  The interest rates tend to be very low because they’re taxpayer subsidized, but it is better to start life with no debt so that you can get into a house and stop paying rent.  If you must take on student debt, take on as little as possible by graduating fast and then keep living like a student for a few years after college until you pay that debt off.
  3. Home Equity Loans:  Again, if you’re taking out a loan on your home, it means you’re buying things you can’t afford.  It is better to save up and pay cash if at all possible.  Plus, HELOCs can carry interest rates of 5-8%, so these will consume a good portion of your income.

“Good” Debt:

  1. Home Loan:  A home loan can be a good debt because it allows you to stop paying rent and leverage the value of an expensive asset, your home, to build wealth.  If you buy a $250,000 home, you’ll get to keep the appreciation on that home, which might be a real help when you’re ready to retire if you’re willing to downsize and/or move to a cheaper area.  Keep these loans at 15 years or less and make sure the rate is fixed.  Plus, keeping your mortgage payment below 25% of your take-home pay will make it a lot easier to make the payments.

Thanks to reader, Jessica, who suggested the topic for this post.  Keep them coming!

Your investing questions are wanted. Please send tovtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

 

3 thoughts on “Poisonous Debt

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  1. Interesting post! My mom always refers to my mortgage as good debt, but we’re in a slightly different situation as we also have rental income, so not only are we building equity, it’s also a steady source of cash flow. Interest on the mortgage is also tax-deductible (because of the rentals).

    I’m on the fence about cars though. We had enough cash to buy our SUV outright back in 2014 (and we had to buy new as we needed a new car that year and the model that we wanted was only being released that year. I still think it was the best decision as the fuel economy for an AWD SUV is amazing – it was better than my Mazda 3 hatchback!!!) but the financing rates were only 1.99%. The dealer was offering the 1st 2 months of payments free IF financed (and no cash incentives) up to a max of $450, so we put a big down payment that would allow a $450 monthly payment over 5 years. It’ll be nice to not have to pay the extra $450 per month in 2019.

    I know cars are just a big money drain, but we live in a commuter city (i.e. no real public transit to speak of) so for us, it’s a necessity. We only have 1 but hoping to get another one next year… I think we’ll need 2 for sure by the time we have a baby.

    1. Thanks for the comment, and thanks for reading. I see wealth building like trying to fill a large wooden barrel with water. Each asset you have is like a hose bringing water into the barrel and each obligation you have is like a hole in the barrel. If you have enough hoses, the barrel will fill itself practically and you can put some pretty big holes in the bottom without an issue. If you more holes than hoses, you need to make up the rest by carrying water by hand (work) or your barrel will run dry. Depending on how much water you can carry, you might be able to make up for a big leak like a car payment, but the fewer leaks you have, the easier it is to fill the barrel.

      A car payment is a huge hole because not only do you pay interest on the debt, but you pay a lot more in depreciation each year than you would with a used car since a car goes down in value 50% each year. For example, a $40,000 car costs you $5,000 in depreciation each year in addition to maybe $5,000 in payments each year. If you make enough money so that you can pay out $10,000 per year for a car and still save a bunch for retirement, kids’ college, and just growing financially independent, that’s fine. The trouble is many people have car payments with new cars every four or five year, but then have no retirement savings and no college savings.

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