In 10 Dirt Simple Rules of Money Management, I provided 10 rules to follow to basically ensure a great financial future. In the next few posts in this series, I’ll provide more information on why they work and how to implement them in your life. (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list.) We’ll start with the first rule:
1. You pay twice as much for something if you borrow money to buy it. Don’t borrow for things that won’t pay back at least two-fold.
Many people don’t think twice before borrowing money to do things. They need a home, so they find a way to put almost no money down, get the longest loan they can find, and get the biggest mortgage for which they can qualify. They choose a college without thinking too much about the cost and a major without thinking about the future salary, then spend five, six, or seven years taking the minimum number of classes and running up student loans all the while without even thinking about the balance or the monthly payments they’ll be facing. Need to remodel the kitchen? Get a home equity loan. Want to go out to dinner or buy some clothes? Whip out the credit card. Need a new air conditioner? Finance it. Need a new car? What will the payments be?
They do all of this, taking out loan after loan after loan until the payments due each month equal or exceed their take-home pay. They then spend the next thirty or forty years wondering why they can’t seem so save up any money. They say it’s unfair that they have student loans to pay. It’s unfair that the bank has a mortgage on their home and will take it if they get behind on payments. They think it’s unfair that the loan on their car is more than the vehicle is worth. It is unfair that the vacation is over and they now need to keep paying for it for the next several years.
Many also start to blame the lenders, and nowadays they have various advocacy groups supporting them (and really enabling their poor financial decisions). The lenders are predatory. Are evil. Are taking advantage of them. They shouldn’t need to pay for the things they bought because obviously they were tricked. They should get to keep their home even though the bank gave them all of the money for it and they’ve only paid back a small percentage. They shouldn’t have to pay for their car because the payments are too high. They shouldn’t need to pay back their student loans because they owe way more than their salary will let them pay in their line of work.
We all make choices, and one smart financial choice you can make is to not borrow money unless you are almost assured of making at least as as a result of taking the loan as you will pay in interest. At a 5% interest rate, your loan value will double in about 15 years. At 10%, it will double in about 8 years. At the kind of rates charged by credit cards, it might double in three or four years, or even two years. This means that if you have a 30-year home mortgage, you’ll pay more than twice the price of the home when you’re done, even if you don’t take money out along the way. With student loans, you’ll pay twice as much if you take 10-20 years to pay them off. That dinner left on a credit card will probably cost you two to three times as much by the time you are done paying for it with minimum payments.
Buying a new car on credit makes no sense because you can buy the same car for half of the price in five years if you save the payments up. You can do even better if you buy four year-old used cars for cash. If you buy a used car from your buddy in four years that he bought new with payments, you’ll pay about 1/4 as much as him for the four years you drive the car if you include both interest and payments. (Just don’t tell your buddy so he’ll buy the car new for you to get later – just kidding.)
It may make sense to buy some things on credit because you do get a better return. Getting a degree in engineering, law, or accounting, which leads to a good paying job that could not be had without a college degree, can be worth a loan since it will pay itself back in your increased earnings. Buying a home can save you money on rent and the appreciation on the home can help offset the interest payments. Even in these cases, however, you’ll be a lot better off minimizing the interest you pay by borrowing as little as you can and paying back the loans quickly. If you’re buying a home, start out with a smaller, less expensive home, save up a 20% down-payment so you won’t have to pay mortgage insurance, and use a 15-year loan so that you cut your interest payments was down and get it paid off before your kids are looking at colleges. If you are taking out a student loan, go to an inexpensive school, get all of the scholarships you can and get through as fast as you can. Then, live like a student for a few more years even though you have a salary so that you can pay off the student loans before you buy a home.
Don’t fall into the trap of believing that you just have to take out loans to get things. It just means waiting a little longer until you can pay cash rather than using credit and paying the interest. You can even earn interest while you’re waiting.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
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