Financial Basics: How to Stay out of Debt

Written by Dave Young, President

DEBT IS NOT ALL BAD. It does have a purpose. I realized this when I went to Tanzania recently.

As we road through the small villages, I noticed several unfinished houses. One had a completed foundation, another had a completed foundation with framing, another had a completed foundation, framing and sheetrock, etc. Each home was unfinished at a different stage and didn't look like it would be finished any time soon.

I was surprised to see so many unfinished homes. I asked our guide why they were like this. He explained that they didn't have an effective banking system for the common man, which meant they couldn't borrow any money. When a person wanted to build a home they had to save up for each part of the home and pay in full before they could continue. Each home took years sometimes to build because they couldn't borrow money.

Without debt, a society cannot progress.

In order to work effectively, debt must be used responsibly. Irresponsible debt can be devastating to your financial future.

To succeed financially, you must AVOID irresponsible debt like the plague. Remember that there are people who receive interest, and there are people that pay interest. Usually, the payers work for the receivers. My goal is to help you understand principles that will make you a receiver.

Debt is effectively compound interest in reverse.

Look at this situation for an example. A person puts away $100 a month for 30 years.

At 5% interest.............................................................................$81,886

At 10% interest..........................................................................$208,084

At 15% interest..........................................................................$564,082

At 20% interest........................................................................$1,567,624

Over a 30 year period, the amount accumulated at 15% is more than seven times greater than the amount accumulated at 5%!

If you are paying the interest rather than receiving it, the higher the interest rate you are paying, the more devastating the consequences.

A credit card has been defined as:

"A means of buying something unneeded, at a price you can't afford, with funds you don't have."

Let's look at some examples of how debt works.

Example 1

Two families have the same income, three children, education expenses to plan for that will cost approximately $33,500.

FAMILY A

Chose to meet this obligation by saving $50 per month over a 20 year period and earning 9% interest.

Their total out-of-pocket cost.........................................................$12,000

FAMILY B

Chose to meet this obligation by borrowing the $33,500 on their home equity line of credit. Their interest rate was 12%. Their payments were $368.40 for 20 years.

Their total out-of-pocket cost.........................................................$88,416

Example 2

A person decides to purchase a new car. They purchased it new for $25,000. They paid $2,500 down and financed $22,500 over five years at 9% interest.

ACTUAL COST.............................................................................$30,523

VALUE AFTER 5 YEARS....................................................................$9,000

Return on investment.......................................................................-71%

Example 3

A person buys a condo and borrowed $250,000 at 6 1/2 percent interest over:

Years                                               Payments                                                 Total Amount

15                                                    $2,177                                                        $391,998

30                                                     1580                                                            568,861

100                                                   1356                                                          1,627,490

500                                                   1354                                                          8,125,000

A 15-year mortgage is optimal. Any longer than 15 pays unnecessary interest.

When is debt okay?    

If it is used to purchase an appreciating asset such as a home, an education, a business, a car (to provide transportation to work), etc.

When is debt NOT okay?

When spent for any depreciating asset. This includes just about everything except what is listed above. Any time you are going into debt for something you don't need and don't have money for, it is NOT okay.

The key to staying in balance is the issue of NEEDS versus WANTS. Everyones needs and wants are different depending on your financial situation. Only you can determine specifically what your needs and wants are and your flexibility.

Four Steps to Help you Stay out of Debt

Step 1-

Put together your personal budget with serious attention to identifying your needs versus your wants.

Step 2-

After your bills are paid and a portion of your income is put into savings, determine what you have left to spend. This is called your discretionary income.

Step 3-

Make a list of wants or things you would like to purchase.

Step 4-

Prioritize your list of wants and then only purchase those things that you actually have cash to use. Do not go into debt by spending money you don't have.

Never spend money you don't have. It sounds simple. It is simple, but it takes discipline. Mastering the proper use of debt is one of the seven steps to building wealth (we will discuss those steps in another article).