In my post The 3 biggest killer of wealth: taxes, interest and inflation I talked about how more Americans are living above their means as a result of the three death killers. In this article I focus on interest and wealth.
Interest is the cost of borrowing money and when used in the case of consumer debt it becomes an additional expense we pay with no real benefits. The more we have to spend the less we have to save and invest. The average American pays $10,954 in interest, this computes to $913 a month. Imagine what you can do with $913 if you did not have to pay it out to the banks. You can go for a real nice vacation with this money.
The four biggest areas of debt are student loans, credit cards, auto loans and mortgage debt. I will discuss each of these next.
Student loans
Student loan debt is accumulated as a result of engaging in some form of formal education. The loan is very easy to get and what makes it very convenient is that you do not have to pay back the loan while you are in school. The bad part about this is the loan accumulates and by the time a student graduates, the debt is so high that most students can’t really wrap their mind about this. This problem becomes even worse if the student cannot find a decent job after graduation.
The most recent report of the Federal Reserve Bank of New York’s Report on Household Debt and Credit, implies that the delinquency rate for student loan debt is increasing. Student loan debt grew by 7% making student loan slightly short of $1.2 trillion.
With statistics like this what does one do to abet the adverse effects of student loan debt? Students often look at student loan debt as easy money. At the beginning of the semester the excess not used for tuition and fees is deposited in the students account. This can make a student feel temporarily rich. The debt feels good until it is time to repay it.
To avoid the pain of paying back this loan, only take a loan for the amount you absolutely need. Before the loan is disbursed you do have the option of accepting or rejecting a loan: You have to think long term when tempted to check the accept checkbox. If you are responsible for your living expenses, work a part time job rather than using your loan money to survive.
Mortgage debt
While student loan debt grew by 7%, mortgage debt grew by merely 1.5%. I personally think that people are too overburdened by student loans and are not buying their home. Unlike student loan and credit card debt, a mortgage could actually be a positive. Depending on property prices in your area, mortgage debt could be a way to live in your house for free. By this I mean that you pay the bank a fee or mortgage for using the house and when you are done you sell the house and get your money back. In some cases you might even get more than you paid. Of course there are a lot of factors that affects this philosophy and great care has to be taken to make sure that getting a mortgage is the best choice depending on your circumstance.
When mortgage debt is abused it could become a curse rather than a blessing for the home owner. This is why it is advisable to seek financial advice before making big purchases like a house.
Auto loans
Most car loans are for less than 5 years and require a fixed payment each month. The problem with auto loans is people buy more car than they can afford thereby increasing their financial burden. Buying a car is a very bad investment because it declines in value very rapidly. I personally think that cars should be bought with cash but I know most people will not agree with me. If you must use a loan to buy a car, keep payments under 20% of your monthly income. However, be careful of smart marketing strategies that reduce your payment but increase your loan.
Credit card debt
Of the three biggest debt, the credit card debt is the one that makes the least sense. Buying stuff you do not need because you do not need to pay for it now is pointless.
I know some people use credit card debt as a source of making ends meet. If this is your situation then you really need to do something to either increase your income or decrease your expenses. Using credit card debt for living expenses should never be the case. You should be able to pay off the amounts your charge on your credit card as they come due. If you cannot do this every month then you are spending too much.
Credit card debt have the highest interest rate averaging 18%. If you owe $15,611 like the average American you will be paying $2,810 in interest. Imagine how much more fun you could have if you did not have to pay that.
On the other hand, if you pay your debt off monthly and you charge $26,400 annually (the average living expenses) you will earn at least $264 in reward credit: this is money you can use to go out for a very nice dinner. Credit card can be good if used wisely but if you lack self-control then stay away from credit cards as they could be your financial downfall.
Finally, spending money on paying interest on consumer debt is a great way to reduce the quality of life: You find yourself too busy paying for yesterday’s expenses that you cannot enjoy today or build tomorrow’s wealth.