Two weeks ago I wrote about my personal financial strategy, and promised to elaborate on its principles in future posts. The first principle was: don’t overspend. This is the most important principle because not spending is the fastest way to accumulate money. It matters more than what job you have, or what investments you buy. It’s also the easiest principle to understand and apply to your life. To avoid overspending you should: avoid debt when possible, and live comfortably without showing off.
Try to Avoid Debt
Debt is the opposite of investing: when you invest you earn interest, when you have debt you pay interest. Notice how I said “try to avoid debt” and not “always avoid debt.” Debt is a calculated risk. If you can do the calculations, and there is a good payback involved, taking on debt is okay. Off the top of my head, I can think of two examples of good debt spending that most people are familiar with: buying a car, and student loans.
Consider a car purchase. If you need a car to go to work, and public transit is inefficient, or too expensive, then financing the purchase of a car makes sense. Although you pay interest on the loan used to buy the car, having the car allows you to go to work and earn your salary, which presumably pays you much more than the interest will cost you. Buying an entry level or used car reduces the size of the loan, and paying the loan off quickly will minimize the interest you pay. This is a reasonable use of debt.
Student loans are also a reasonable use of debt, provided that the education you are receiving will significantly increase your earning potential. My colleague at work (also 25 years old) is a good example. He took student loans to finance his computer science degree, and then used that credential to land a job that pays $70k per year. If he aggressively pays his loans, his first year of work will repay them completely. The benefit he derives from this debt financed education is enormous. The difference in salary between his job now and his previous job as a warehouse employee is on the order of $50k per year. Over the next 40 years of his career, he can expect to make 40*$50k = $2M more than he would without his degree.
Credit Cards Suck
Having established that not all debt is bad, it’s time to talk about debt that is bad. Credit card debt is a common problem. Many people carry balances on their credit card, and seem blissfully unaware of the cost of doing so. As a math person, I always assumed that this stupidity was due to a lack of math skill. Most people do not calculate the amount they are losing in interest payments. Having never done any calculations, they are unaware of how bad the deal is.
It is really easy to illustrate why credit cards suck. A typical credit card charges about 20% interest per year. Carrying a credit card balance of $1000 for a year will cost you $200 in interest payments. At first glance, this doesn’t sound so bad – it’s less than a dollar per day. Compare this to a safe investment like a government bond or GIC, which currently pays around 2% interest per year. There is a tenfold difference in the interest rate of the bond and credit card! To make that $200 back by investing, you need to buy a $10,000 bond and hold it for a year. Losing money on credit card interest payments happens ten times faster than earning it back with investing. Carrying even small amounts of credit card debt obliterates anything you do with your savings. This is what makes the first principle more important than the others. Not carrying a $1000 balance on your credit card earns you as much money as having $10,000 in the bank.
Credit Card Rewards
When offering such a bad deal, credit cards must offer consumers some real benefits to get them signed up. The most popular way is by offering some sort of rewards scheme. My VISA card offers reward points: 1 point for every $2 spent. Points can be redeemed online for merchandise. I did a few quick calculations and determined that gift cards are the best value. A gift card for $25 costs 3000 points, which means I get $25 back for $6000 in charges to my credit card, with the return being 25/6000 = 0.416%. Notice the scale of those numbers. Rewards are nice, but a single month where I carry a balance completely negates any rewards I get for a year’s worth of expenses.
Another small way to benefit from credit cards is using them to avoid debit card transaction fees. Banks will allow you a small number of free debit transactions, after which they will charge you a fee for each transaction. My bank allows 10 free transactions per month, and charges $1.50 for additional transactions. If you make many small purchases in a month, these fees could add up to significant waste. Credit cards have no such fees; thus, consumers can avoid the debit fees by paying for everything on credit, and making a single transaction per month to pay the credit card bill.
Technologically, debit cards and credit cards do the same thing: you swipe a card and buy stuff. The important difference is that debit cards deduct money you actually have from your account. Credit cards allow you to buy stuff with money you don’t have, and if you carry a balance, they charge you even more money you don’t have. You may hear credit cards described as a method of “payment deferral,” which is true if you never carry a balance. The moment you begin carrying a balance, you are not merely deferring payment, but increasing the size of your payment by paying interest on it. Credit cards have no fees to encourage overspending, since more purchases means a greater chance of you carrying a balance and paying 20% interest on it.
Live Comfortably and Don’t Show Off
Unreasonable use of debt can occur in the same scenarios that good debt spending occurs, usually as a result of trying to show off, or compete with others. A fancy car adds almost the same value to your life as a cheaper vehicle. They both get you to work, but fancier cars add unnecessary expenses. A university degree that doesn’t lead to a significant increase in your salary may not be worth paying thousands of dollars in student loan interest. Are you doing a degree because it will pay off, because you want to do it, or because your parents or society makes you feel it is your only option? This is not to say that driving fancy cars is always bad, or some university degrees are worthless. It all depends on your situation. Especially if you need to support yourself and others, or if you aspire to be financially independent, you should consider the real costs and benefits of your debt spending.