The ABCs of Debt

Everyone knows what debt is: It’s money you owe to other people –specifically, to people you never see who work in banks, finance companies, mortgage companies and credit card firms. It’s “easy money” but it’s also the greatest stumbling block to your financial freedom and independence.
People sometimes think of their debts as just another kind of expense. Debts are budget items to them, not unlike their phone bills and weekly allotment for food and entertainment. But there is a big difference between a debt and an expense.
An expense is something you must pay regularly, such as the electric bill or college tuition, that gives you something of value in return –electricity or an education. When you pay an expense, you are simply exchanging money for something you need. An expense grows only in proportion to your need (or inflation, of course); interest does not make it grow, because an expense incurs no interest. Most importantly, though, normal living expenses generally do not erode your wealth-building capacity.
A debt, on the other hand, is a liability. It offsets your net worth. If you have $100,000 in assets but owe $110,000 in debts, you are obviously in trouble-and you don’t even need a financial expert to tell you that.
Unlike an expense, a debt usually incurs interest charges; you pay for the “privilege” of being indebted. The interest further eats into your ability to get ahead financially or to work on creating wealth. When you pay your consumer debts, you are not getting anything of value in return. All you are getting is a little less indebted, unless, of course, you continue to use credit and get further into debt.
Also, debts grow automatically, not in proportion to your needs. This is one of the biggest ways they keep you from achieving financial freedom. Let’s assume you charge a $5,000 stereo and big-screen TV on your credit card, which charges 18 percent interest. If you make no more purchases on that card and pay $180 a month, in three years that stereo and TV will cost you not $5,000 but $6,500 –30 percent more than if you had paid for it in cash!
If you’re even a moderately savvy shopper, you certainly would not pay $6,500 cash for an entertainment system that is worth only $5,000. But somehow, with credit, we figure it’s not the same. People will half jokingly say, “I’ll use my credit card; it’s not real money.” It IS REAL MONEY … and Very Expensive Money too! Yes, if you are in debt, it will take time to get from where you are now to where you need to be (debt-free). But it can be done. First, you must start with the groundwork, getting to know the basics of debt. So let’s get started…
Where It All Goes
Debt comes in all types and styles. Here are the most common types of credit available, along with some facts to help you keep them in perspective:

* Automobile Loans
Most of us need automobiles, and an automobile is the second most expensive purchase many of us make (next to our home). With the incredible increases in automobile prices over the last several years, it’s no wonder that a high percentage of all late-model autos on the road today are financed by a bank, credit union or finance company. If you absolutely must take out a loan to purchase an automobile, make the loan term as short as possible. And then do everything you can to pay it off early. Also, shop around for the best auto loan deal. The dealer will probably try to sell you on in-house financing, but don’t take it without looking around for something better. You’ll probably find a lower rate at a credit union or even a bank.
Don’t purchase a new car and be very cautious about enticingly low lease payments. New cars lose as much as 30 percent of their value once you drive them off the lot. They lose approximately 50 percent of their value in the first 2 years. So should you ever purchase a NEW car? Answer: You may choose to do that at a time when you are debt-free and can do so for CASH. But by then you may not want to spend your money in that fashion. Watch out for those car ads that stress “Low Monthly Payments.” You’ll get low monthly payments but for longer terms, often 5 or 6 years. This means your total finance charges (interest) will be HUGE.
A relatively new trend is “Buy Here… Pay Here.” Usually no mention is made of the word INTEREST. That’s because the interest is factored into the base price of the car. Most of the cars found on these lots are high mileage vehicles. The dealers cater to people with limited or poor credit who have few choices when it comes to financing. So the dealers purchase these cars for deep discounts at wholesale auctions. Then they ‘jack up’ the price and sell them with built-in financing and built-in (undisclosed) Interest. People who purchase at these lots generally pay 30 to 50 percent more than they should for the particular vehicle.

* Credit Cards
Between 1980 and 1990, the number of credit cards in circulation jumped from 556 million to more than one billion. These little pieces of plastic are obviously popular, but they can be the biggest debt problem for the consumer.

Credit card debt costs more than virtually any other type of loan (except, perhaps, for the quick but outrageously expensive cash you might get from a loan shark). The minimum payments are small, typically around 1.5 to 2.5 percent of the outstanding balance and interest, so the temptation is always there to “wait until next month to pay it all off.” Of course, when next month’s bill comes, so does the temptation to delay the big payment. There is always some reason to pay only the minimum.
I’m not saying that you should tear up all your credit cards. They can be extremely helpful in an emergency. But after you get down to a zero balance (with the help of this book), get in the habit of paying off your credit card balance every month. This one discipline will be the single most important thing you do to maintain a debt-free state.
If you don’t think you can do this with your Visa(R) or MasterCard(R), consider getting an American Express(R) or Diner’s Club(R) card; they usually require payment of the entire balance every month, so you can’t carry over debt endlessly. A word of warning, though: These cards typically have significantly higher fees than Visa and MasterCard. And sometimes they offer “convenience checks” as a way to extend you a loan. If you cash these checks, you’ll be stepping right back into the debt cycle.

* Finance Company Loans
When you buy a big-ticket item, like a major appliance, the merchant may offer you financing. Except in the case of big national retail stores, however, the financing is probably coming from a finance company. Finance companies are primarily designed to lend money to people who can’t get cheaper loans because of poor credit. As a result, finance companies (often called “Consumer Finance Companies) have some of the highest interest rates around, so watch your step.
Unless the item you are buying fills an immediate emergent need, delay the purchase. Establish a savings plan for the purchase and put away money each time you get paid until you can purchase it CASH. Don’t be misled by sales campaigns. Your so-called savings can quickly be eaten up by interest payments if you take a loan to make the purchase at the sale price. Besides, the item or one like it will, in all likelihood, go on sale again.

* Secured Loans
These are any loans you make using your own assets as collateral. A good example of a secured loan is the home equity loan, which uses your home as collateral. In other words, you guarantee the repayment of the loan plus interest by giving the lender the right to take your specified assets if you do not repay as agreed.Another example of a secured loan is money you borrow against your stocks and bonds. This is known as borrowing on margin, and it’s a risky venture. If your collateralized stocks and bonds drop in market value beyond a specified amount, you will have to come up with additional cash to add to your collateral. If you had to borrow against your stocks and bonds in the first place, the chances are slim that you will have ready access to such additional cash.
The most frightening thing about secured loans is what you stand to lose if, for some reason (layoff, for instance), you can’t make good on the loan. You could find yourself without a roof over your family’s head.

* Unsecured Loans
Unlike secured loans, unsecured loans do not require collateral. However, they do require a squeaky-clean credit rating and visible assets. Qualifying is tough, and this type of loan may have a higher interest rate because the lender is taking a bigger risk. In other words, the lender is loaning money that is not ‘guaranteed’ by collateral. Sometimes, unsecured loans are called signature loans, because, after you qualify, all you need to do is sign your name to a promissory note.

* Mortgages
Mortgages are a “special case” in the world of debt. I will talk about them at length in a separate chapter later in this book.

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