Each year I pull at least 500 credit reports as part of helping people obtain a home mortgage. In analyzing them, Im finding that far too many people are drowning in debt. This month, Im sharing my thoughts with you on the difference between good debt and bad debt. Understanding the difference between the two can save your financial life. As the title suggests, not all debt is bad. Good debt helps you obtain assets that produce income. If taking out a loan will eventually put you in a better financial position, chances are it is good debt. Your home, for example, was probably one of the best investments youve ever made. Bad debt, on the other hand, steals your money and produces no income or cash flow. It is money borrowed for something that loses value, such as a car, clothing, and electronics, to name a few. Earlier this year, the Federal Reserve reported 2005 numbers on consumer debt: Non-mortgage consumer debt climbed to $2.1 trillion. Based on that number, the average household has more than $17,000 in bad debt. Considering that most families have at least one car loan on top of the credit card debt they might be carrying, $17,000 actually seems low to me. For whatever reason, most of us dont think that our car payments are bad debt. I think we have to remind ourselves that car loans are bad debt. Most new-car buyers are unaware that they are choosing the rich, but short-lived, new-car smell over long-term financial fitness. Why do I say this? Well, it has long been established that a new car depreciates an average of 20% in just the first year. Thus, it makes more sense to buy a pre-owned vehicle and let the first owner swallow that first big chunk of depreciation for you. Heres an example of how doing that would contribute greatly to your long-term financial success. The popular 2006 Toyota Camry or Honda Accord costs roughly $25,000 new. What if, instead of buying that brand new car, you purchased a two-year-old, pre-owned vehicle for $15,000 and invested the other $10,000? In this example, if you were to invest the $10,000 in a mutual fund earning 8% and leave it alone for the next 30 years, you would have stockpiled a little more than $100,000. And, if you left it alone for another 10 years, it would grow to about $217,000all because you made a wise decision about buying a car 40 years earlier. The other area that attracts bad debt is money we spend on clothing, electronics and eating out. The truth is that most of this spending winds up on credit cards. My wife and I are diligent in keeping a budget and it still amazes me that at the end of every month, when we review the VISA bill together, we are dumbfounded as to how it got so high. Upon review, however, we cannot disagree with the charges and commit to once again trying to make responsible purchases. As consumers, we all need to use credit wisely and pay it off at the end of every month. I cant stress this enough. If you dont have the ability to pay your credit card bill off each month then the reality of your situation is that you are spending more that you are making. One of the best ways to tackle your credit card balances is to stop using credit cards altogether and use only cash for purchases until youve paid off the balances in full. Studies show that consumers spend far less if they use cash versus credit. At the very least, when using cash, you cant spend more than you have. Another solution is to get a low-interest loan, home equity line of credit, or cash-out refinance to consolidate high interest rate credit cards. My only warning is to make sure that when you use your homes equity to pay off credit cards, you address the root spending problem so you dont find yourself months or years later with a higher mortgage balance and credit card balances once again. A good way to start finding out the truth about your spending is to keep a written journal and track all your spending for four weeks. As you go throughout your day, write down all items purchased and the price for each from beverages and video rentals, to ordinary household expenses to dining out. Get everyone who lives in the household involved in this exercise. At the end of the four weeks, simply tally up the entries to see how much you spent. Whether you know it or not, by doing this exercise you have laid the groundwork necessary in setting up a budget. To be sure, gaining control of your financial situation requires a working budget and a willingness to stick to that budget. Review the budget regularly, identify wasteful spending and eliminate it. If you need help, you are welcome to call me and I can provide you with the budgeting tools I have created over the years to help my own family. One of the resources I use in budgeting is an excellent on-line system called Mvelopes. You can find more information about this tool at www.Mvelopes.com. They do offer a free 30-day trial. Until next time, spend wisely! |
