Money 102: A Hard Liability

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Money 101: Why You Should Manage It Carefully

How a debt works

Debt is essentially “renting” money and has three parts to it

  • Principal – the amount you are borrowing (e.g., $1000)
  • Interest – the rent you pay to profit the lender (e.g., 10%)
  • Amortization – the frequency of calculating the remaining debt (e.g., monthly)

1. A loan contract agrees on the item’s value (e.g., $1000), interest rate (e.g., 10%) across a period (e.g., monthly), and the minimum payment (e.g., $20/month)

2. The lender expects the minimum payment (e.g., $20)

  • Not paying or underpaying will often incur late fees
  • Any overpaid amount goes straight to the principal
  • The remaining balance is re-amortized

3. Loans with higher balances often stagger payments toward interest

  1. The lender assumes standard minimum payments and calculates all future interest they’ll receive (e.g., $1000 at 10% across 65 months is $299)
  2. The majority of each initial payment goes to interest (e.g., Month 1’s $20 puts $19 to interest and $1 to principal)
  3. Overpayment goes directly to the principal, assuming the loan hasn’t specified differently (Month 2’s $30 sends $19 to interest and $11 to principal)
  4. Near the end of the loan’s life, the principal is a more significant portion of the payment (Month 40’s $20 directs $4 to interest and $16 to principal)
  5. This staggered payment ratio makes paying for the loan much more expensive by making minimum payments than paying it off early

Debt companies continuously market their product with lies

Billions of dollars have funded these lies because of trillions of dollars of profit

We’ve heard them for so many decades to where it’s often offensive to refute them

  • Marketers sell debt at different angles, but it’s always a product designed to fulfill instant gratification
  • If credit card payments are typical bill payments, it’s the sign of a financial crisis
  • Society has always viewed debt as universally bad until the idea of “good debt” was marketed in the 1960’s
  • Having a credit card is an inherent risk, not an inherent security

Nothing large or small is “good” to go into debt for

Debt guarantees added stress and risk, and high-dollar debt is more stress and risk

Loan consolidation is usually bad for several reasons

  1. Debt consolidations often add in lower-interest loans
  2. Borrowing from A to pay off B changes the owner of your debt, which can have unforeseen consequences
  3. Smaller payments will compound more interest
  4. Psychologically, it’s far too convenient to use a freed-up line of credit
  5. Paying off one colossal loan is more daunting than many smaller loans

Cosigning a loan is always a bad idea

  • Anyone who needs a cosigner has been deemed unlikely to pay
  • You will be chased down by collectors for the unpaid amount if they don’t make a payment for any reason

Financing, a sophisticated term for debt, is marketed as a tool for “necessary” purchases, but companies make much more money from borrowers than from straight purchasers

  • If an item depreciates over time (e.g., furniture, mattresses, luxury items) it’s always a risk to borrow against it
  • Sell or don’t buy anything that takes more than 18-24 months to pay off

Automobiles don’t need financing to purchase

  • New vehicles lose about 60% of their value in the first four years
  • Most self-made millionaires drive 5 to 15-year-old used cars
  • Much more on proper vehicle ownership later

Only two kinds of debt are even worth considering

  • Homes
    • Only if the mortgage is within 25-50% of your income and the market isn’t inflated (more on this later)
  • Education
    • Only if the training reasonably ensures a return on the investment (more on this later as well)

Payday loans sound sensible for an emergency but contain incredibly high fees and extortionate rates

Credit card vendors sweeten the sale of debt products with rewards programs and incentives

T-shirts and coffee mugs are worth far less than one maxed credit card payments

Accumulating points isn’t an investment or a savvy way to spend

  • Reward points are commonly unredeemed
  • Many rewards program points have expiration dates and limits to the scope for using them
  • The value of diligent points accumulation can be invalidated by a few months of interest payments, even with double or triple points
  • Donating points to charity is another game to attach positive feelings to debt
  • Cashback is less useful than cash

Low card fees are usually not worth it

  • A 0% interest rate for 18 months will inspire the habit of using the card as a bank account for 18 months
  • No annual fees for the first year imply them for subsequent years

Online purchases do not need credit cards

  • Bank debit cards are just as fraud-protected and sufficient as credit cards for every possible online purchase

Science has proven that we spend more with credit cards because of the extra degree of emotional separation from our money

A credit score is, bluntly, an “I love debt score”

Credit scores have no bearing on financial success

Credit reports are compiled by three different bureaus (Equifax, Experian, TransUnion) and determine how likely you’ll repay a loan

  • There are technically several credit scores based on small variations in data
  • Employers can use it without the credit portion
  • It can be obtained for free at least once a year from each of the bureaus

Credit reports pull data from the past 7-10 years

  • Demographic information
    • Name and any other names
    • Phone numbers
    • Birthdate
    • Current/past addresses (can be negatively marked by frequently moving or filing inaccurately with the government)
  • 35% – past payment history
    • Any bankruptcies or judgments in the past ten years
    • Bank overdrafts
    • Missing or on-time bill payments
  • 30% – debt level
    • Credit accounts and their limits
    • Unused credit accounts that are left open
    • A manageable percentage of your income going to payments is considered best
  • 15% – length of your credit history
    • The longer the history of loans, the better it looks
  • 10% – new credit
    • Credit cards, large purchases, mobile phone and rent contracts, mortgages
    • Personal loans
    • How often you apply for credit and where (less is better)
  • 10% – the types of credit
    • Any financial associates and bank details (fewer banks are better)

Debt isn’t a financial tool

If you want to build wealth, stop seeing debt as an acceptable way of life

Debt is a necessary evil to be avoided as much as possible

  • Most millionaires believe debt is financial slavery

The only escape to indebtedness is to overpay every month

  • Make an additional payment on top of the standard one
  • Round payments up to more substantial amounts
  • Make a significant payment whenever you get a windfall like a raise or bonus
  • Call the creditor before the due date to gain some forgiveness from late fees if you know your payment will be late

Debt collectors are very unscrupulous

The collector’s job isn’t to be your friend or help you out of your situation

  • Their job is to get the money you owe

They will try to induce strong emotional reactions of fear or anger from you

  • Strong reactions will motivate you to pay them back

In a debt-lender relationship, you do have some rights

Unless the lender is the government, a creditor can only garnish your wages or take money from your account if they sue you and win

It’s illegal for collectors to harass you or call between 9 p.m. and 8 a.m. unless you have given them permission to

You have the right to demand they stop calling you at work

You have the right to demand they stop all contact with you with the exception that they notify they’re suing you

  • Stopping contact halts any chance of a favorable resolution through negotiation
  • The inability to negotiate will increase the likelihood of getting sued
  • They will likely win a lawsuit since you legitimately owe them money

The only way to fight debt in the long-term is to make a workable budget

Next: Money 103: Setting Goals & Budgeting