Manage Your Debt
Think of your lifetime income and earnings as a pipeline that flows from
when you start making money to the last day of your life. Along the way,
various faucets in the pipeline open and divert money to pay for needs (such
as living expenses, a home purchase, furniture, and transportation) and
wants (like big-screen TVs, vacations, a fishing boat, and more). For items
you buy using debt — mortgages, loans, credit card purchases — the faucet
opens wider and runs longer because you’re paying not only for the item but
also for interest. The result is that you have to either work longer to earn
more money to repay the debt or scale back on your goals.
When uncertain economic times occur, the amount of debt you’ve accumulated
can magnify the threat to your financial well-being. After you sign on for
a debt, you no longer control that faucet. If something unexpected occurs,
you have less cash flow and fewer options. This strategy explains how to
close those faucets and keep the pipeline from running dry.
Avoid Bad Debt
The best way to keep your income pipeline filled is by avoiding unnecessary
debt. Not only does setting aside money for future expenses save you
the cost of debt interest payments, but it can also earn money for you if you
invest in an interest-bearing account. As you save, you help fill your pipeline
instead of draining it!
Putting off purchases until you’ve saved enough also gives you an additional
reserve beyond your emergency fund (see Strategy #10). For example, if
you’re saving money for a new barbecue, you can instead use those funds to
replace a clothes dryer that tumbled its last towel or any other unexpected
expense that exceeds your emergency fund.
But like most people, you can’t afford to pay cash for everything. Buying your
home most likely required a mortgage. Buying cars, furniture, and appliances
may involve financing. When you can’t pay cash for high-cost items, you need
to borrow at least some of the amount needed for your purchase.
Four criteria determine whether debt is good or bad. Before taking on debt,
ask yourself the following questions. If the answer to all four questions is yes,
you’re signing up for good debt:
- Is it a need? If dependable transportation is a requirement for your job,
buying a car to replace one that’s on its last legs is clearly a need. But
if you have a working TV and those ads for big-screen flat-panel models
are making your mouth water, you’re looking at a want — which leads to
bad debt.
Note: Where you live is important for your quality of life, so although
you can live in an apartment, you may choose to buy a home to provide
a more desirable environment, which would qualify as a need on the
scorecard.
- Do you need to buy it before you can save up for it? Consider the
timing. You’re looking at good debt if your car is beyond repair and you
need dependable transportation as soon as possible. If the big-screen
TV is on sale this weekend, you can wait. (Do you think they’ll get more
expensive as time goes on?)
- Can you afford the payment? If the payment fits in your budget, you
won’t have to cut back on other needs. That’s good debt. If you can’t
afford it, you’ll have to cut back on some newly defined “extras” — like
gas, food, and braces for the kids.
- Are the financing terms okay? Check the
- Rate
- Terms
- Prepayment penalties (which should be none)
With good debt, you may have checked with your bank, credit union,
and so on, so you know the interest rate is competitive and the length of
the car loan isn’t longer than 48 months. You’re into bad debt if you use
the in-store financing offered by the salesperson to buy the TV, getting
saddled with an early-payment penalty.
Saving up for a future expenditure keeps you in control of your money. By
signing up for debt, you give away that control. Avoiding bad debt keeps more
money in your income pipeline going towards your needs, wants, and other
goals.
