CHAPTER THREE
Thou shalt not carry credit card balances!
Debt can cripple people’s finances. It can ruin marriages and relationships. It can make you miserable. And it can handcuff you, keeping you from realizing your financial potential. This applies to any high-interest debt. It could be a charge card, department store card, whatever.
When you have a lot of debt, the amount of cash flow it ties up on a monthly basis is painful to calculate. Especially when it’s in the form of high-interest debt. There are families spending thousands of dollars a month in interest payments on credit cards. I recently met a family with more than $50,000 in credit card debt. At an average 28% rate of interest, they are paying $14,000 per year, or $1,166.67 per month, just to carry the debt. They might pay this forever if they don’t pay it down. After 10 years, they will have paid $140,000 in interest without putting a dent in the debt itself.
They didn’t start out with $50,000 in credit card debt, it crept up on them over time. And there are many people in the same situation.
Even paying $200 per month in interest on a credit card, charge card, department-store card, or whatever-card debt is deflating. Most people at some point wonder to themselves, “What could I do with the money I’m losing to interest every month?” If you can’t pay off your credit card balance in full every month, you are using debt irresponsibly.
Credit cards have some fine rewards programs, but they work out to an equivalent of roughly 2% of what you spend. Carry a balance and you could be paying 28% interest in perpetuity. In that case, those incentives to use your credit card to earn travel rewards are costing you money, not making you money. So forget about rewards programs as a reason to use credit cards if you carry a balance.
I often come across people with multiple maxed-out, or nearly maxed-out, credit cards. They might have a secured line of credit, car loan, student loan, mortgage, and almost invariably a loan to a furniture store. They are drowning in debt. In some cases, they don’t stop spending more than they earn until they run out of credit.
They all had the ability to stop overspending on their own. The fact that their overspending stopped because they were denied access to more credit means someone else is in control, not them.
The cost of carrying debt in perpetuity is astounding. A family that carries an average $5,000 balance during their working career will spend about $70,000 in credit card interest. Seventy thousand dollars is a lot of money to pay for spending $5,000 once. This kind of overspending is not unusual. According to the U.S. Federal Reserve, in late 2012 the average credit card balance for American households that had a balance owing was just over $15,000. Eventually, people can get to a point where they’ve had enough. They decide they want to be the ones in control and are ready to do what it takes to run a surplus and pay down their debts. But sometimes they are confused about how to tackle it all.
Assuming you are now running a surplus, where do you direct your funds to give you the best bang for your buck?
1. TRANSFER HIGH-INTEREST BALANCES TO LOW-INTEREST BALANCES
If you have room on a line of credit, start by transferring the credit card balances there. A credit card with a $5,000 balance at 28% interest is costing you more than $115 in interest per month. Transfer that to a line of credit that charges 5%, and you’ve saved yourself almost $100 per month—which must go towards paying down the line of credit. The next thing you need to do is call your credit card company and have the credit limit reduced or have the card cancelled to prevent you from getting into trouble again. I know some people may rely on credit as their emergency reserve, but I also know they have multiple credit cards.
Once you’ve shifted your balances to the lowestinterest-rate facilities, you need to ensure that you don’t use your credit cards, or get a new loan, or borrow in any other way, until you’re rehabilitated. Freeze your cards in a block of ice, cut them up, do whatever it takes to prevent you from using them.
2. DEVELOP A PLAN OF ATTACK FOR PAYING DOWN YOUR DEBT
Create a list of all your debts, not including the mortgage. If you have three credit cards, all with a balance, list them. Many people have no rhyme or reason in their approach to paying their credit card bills. If they have $600 per month dedicated to paying off the three cards, they may pay $200 to each. That’s not ideal. You need to focus on paying them off one at a time, while still meeting your minimum payments on each one (and slightly more than just the minimum is okay). That might mean payments of $50 per month to two of the cards and $500 per month to one card. The question is, which card do you pay off first?
You can either pay off the cards in order of highest interest rate first and lowest interest rate last, or begin with the card that has the lowest balance and deal with the one that has the highest balance last. Once one card is paid off, you focus on the next card until they are all paid off.
If you pay off the card with the highest interest rate, you’re reducing your overall interest payments fastest and, from a pure numbers standpoint, it’s the best way to go. It makes you debt-free the fastest, although usually not by a landslide. But, in my experience, people respond better to paying off the card with the smallest balance first. The psychological victory they enjoy by slaying a credit card once and for all is a powerful motivator.
Now, the next card in line receives a $550 monthly payment ($500 plus the $50 minimum payment you were making before). Once that’s paid off, the last card gets $600 per month. This is commonly referred to as the “debt snowball” method. Unless you have strong objections to the approach, use the snowball method and pick the debt that will get paid off the fastest, regardless of interest rate. Don’t over-think it, just do it.
A word of caution to anyone thinking about taking credit card and other debt balances and adding them onto your mortgage. The idea that you can “consolidate” debt into your mortgage is sometimes offered as an attractive solution to a heavy debt burden. The illustrations and calculations can show monthly increases of freed-up cash to the tune of hundreds of dollars, because a 25-year loan at 4% for $10,000 in debt doesn’t cost as much as an open-ended $10,000 balance on a credit card at 28%. Many see it as a fresh start. Just one debt payment—the mortgage, and no credit card debt.
But not everyone who consolidates their debts has learned their lesson. In many cases, they’ve just given themselves more rope with which to hang themselves. I’ve seen cases where people consolidated multiple times because they kept on overspending. They may have started with a $250,000 mortgage, and 10 years later it’s $300,000: they can do this only owing to the fact that real estate has been increasing in value steadily for the better part of two decades. That increase allows them to use the built-up equity in their home to finance dumb spending decisions. They clean up their credit card debt only to rack it up again. Wash, rinse, repeat. That’s great advice for shampooing your hair, awful advice for managing your debt.
Don’t say you haven’t been warned. A debt Armageddon is entirely possible in Canada’s future.
IT’S NOT THAT SIMPLE
As with all of the fundamentals of managing your personal finances, the theory and formulas are far from being rocket science. Unfortunately, it’s not the theory that trips us up: it’s the implementation. You have to understand that your life is going to have to change if you want to see actual change. Prescriptions for getting your finances in order are just like the thousands of diets and workout regimens out there: the information is useless until you exert discipline and self-control in order to follow the steps.
A numbers-based solution to a psychologically rooted problem won’t resonate with some people. You either have to fall far enough for the problem to stress and consume you, or you have to educate yourself about just why you should hate debt with a passion.1 It’s kind of ironic when you think about it: some people take on debt in order to consume things until debt consumes them.
If you want to spend more, save more. If you understand and embrace this fundamental precept—that you should be earning interest instead of paying it—you’ll be better off than most people. I’ll end this chapter with a few thoughts about debt.
Financing a $35,000-car might cost you $43,000 after factoring in the interest you pay, but saving up for it in advance might earn you $1,000 in interest, so you only have to put aside $34,000. That’s a $9,000 difference out of your pocket for that same car. The average person might own nine cars in a lifetime. So the average couple might own 18 cars: 18 × $9,000 = $162,000. That’s four more cars you could have bought. Or fancier cars. Or you might find that when you have $35,000 sitting in your short-term savings account, you’re less likely to buy a $35,000 car, because it’s harder to part with $35,000 of cash than it is to buy a $35,000 car on credit. Then you have more money for other stuff.
Something to consider when you borrow money from a bank is that you aren’t ultimately borrowing money from the bank. You’re borrowing it from your future self. The bank is just the middleman between the two of you, and it charges you interest for its services. That interest charge means that not only are you spending your future income today, you get to spend less of it because there is a cost (interest) in order to access it. Think of borrowing money as negotiating a paycut with your future self. Eventually you will become your future self, and you might not be very happy.
So how does one go from financing cars to saving up for them in advance? Wouldn’t that mean waiting for the loan on your current car to end and then saving up for the next car first? Yes, it would. In the first place, a car should last 10 years these days without breaking a sweat. And second, quite frankly, if it seems like a struggle to save up that money, that’s a clear sign you can’t afford a $35,000 car yet.
A car has to be reliable and get you from A to B. All entry-level compact cars fit that description. Anything above that is a luxury, a want. I don’t care if you buy a top-of-the-line Mercedes-Benz—if you can afford it. But until you have mastered money, aim for the cheapest car that meets your regular needs. A friend of mine recently told me that he bought a slightly used sub-compact car for $12,000 because I gave him this rant a year ago. He earns well into six figures, but he said that, just by holding back on that car, all his money stress is gone. His friends couldn’t care less that he isn’t driving a luxury cruiser.
Everything that makes a cool car a cool car is not so cool after a few months of driving. Then it just gets you from A to B like every other car you’ve owned or will own. It’s 90% in your head.
Gail Vaz-Oxlade’s Money Rules is a great book with lots of common sense (and tough-love) approaches to managing your money (and your debts). This is another book I recommend for those who want to graduate up from an easy A to an A+, or who need help mastering some of the fundamentals.
1 I had the honour of being invited to give a TEDx Talk recently. For those of you who are not familiar with TED Talks, they are the product of a non-profit organization that challenges speakers to “give the talk of their life” in 18 minutes or less. It’s about spreading ideas and challenging what we think. A TEDx event is a locally organized TED event and my alma mater, the University of Toronto Scarborough (UTSC), hosted one. My presentation was about why we should start hating debt again—because people used to detest it in “the olden days.” My talk is titled, “Why 2.5 Billion Heartbeats Might Change the Way You Think About Money,” and I’ll shamelessly suggest you watch it. Many people who were blasé about debt before the talk changed their minds about it, even though debt wasn’t consuming them. You can search for the title online, or tweet me @preetbanerjee, and I’ll send you the link.