Debt is when we owe a person, company or bank money. Essentially, we borrow from the future to pay for today. We commit to pay a portion of our income going forward for something we purchased in the past. Debt is the equivalent to overeating when it comes to nutrition. You are consuming more calories than you are expending in energy which leads to weight gain. In money terms we are not financially fit.
There is no such thing as good debt. There is bad debt and less bad debt or what we might term as necessary debt. Debt with a high interest rate or used to purchase a depreciating asset would be considered bad debt. A depreciating asset is one that goes down in value, a car for example. A low interest rate or appreciating asset would be considered less bad or necessary debt. An appreciating asset is one that goes up in value, a property for example. There are different types of debt such as family loan, business loan, overdraft, credit card, pay day loan, buy now pay later financing, bill pay phones, car loan, personal contract plan commonly known as PCP, hire purchase, leasing, personal loan, mortgage and so on. We can breakdown these types of debt into secured and unsecured. Secured debt is secured against the physical item purchased. An example of this is a car lease where we pay for the use of the car every month but do not own it until the final payment. The car’s depreciating value is what the debt is secured against. If for any reason you are unable to make the repayments, the car can be repossessed and used as payment or part payment (collateral) against your outstanding balance due. The interest rate attached to the debt should reflect that it is an asset backed debt, the car in this instance, and therefore less risky than unsecured debt. Unsecured debt is not secured against a physical item purchased. An example of unsecured debt is a medical emergency, holiday, student loan, wedding, credit card, overdraft and so on. Unsecured debt is intangible with no intrinsic value. Intrinsic value is the measure of what an asset is worth. The interest rate for unsecured debt is likely to be higher given the risk to the lender without a physical asset to secure the debt against. The reality is most of us will have some interaction with debt in one form or another throughout our lives. Debt can be a necessary tool when buying a home but for many it is a major roadblock when trying to build wealth.
Banks and some businesses are built on lending and therefore it is no surprise we pay more to borrow by paying interest. Interest is charged on the outstanding loan balance. Principal is the amount borrowed. Outstanding balance is the principal less repayments to date. Therefore, our repayments will be a combination of outstanding balance and interest. At the start of a loan, the interest part of the repayment will be highest as this is when the outstanding balance will be highest. With each repayment, the interest portion of the repayment reduces in line with the outstanding balance. For example, say we have borrowed €100,000 with a fixed interest rate of 3% over 10 years repaid monthly. A fixed interest means that the interest rate stays at 3% for the 10-year term. The repayment amount will remain fixed at €966 per month. The first repayment of €966 will be a combination of €250 in interest and €716 in principle. The €716 principal part of the repayment is then subtracted from the €100,000 balance giving us €99,284 and the interest part of the next repayment is calculated on this new lower outstanding balance. So, the next repayment of €966 will be made up of €248 in interest and €718 in principal and so on until the loan is repaid in full in 10 years’ time. When we choose debt, we spend our future income and it costs us more to do so. The total interest paid in the above example will be over €15,000 for a total repayment of over €115,000 across 10 years. Based on our income per hour after tax, discussed in episode 2, how many more weeks or months will we have to spend at work to pay the interest alone? It is also important to note that while current interest rates are low this might not always be the case. This is especially important for those with mortgages. Making a thirty-year borrowing decision based on interest rates of today can be short sighted. With any long term financial decision I find it useful to go back the period of time for which the decision is being made. So, if it’s a thirty-year mortgage I go back to 1990 and see what the interest rate history was like over this period in the past in order to have a reasonable understanding of a similar experience over the course of the next thirty years. Nobody has a crystal ball. The past won’t predict the future but the future is born out of the past. It remains our only yardstick from which to guide ourselves into the future. Double digit mortgage interest rates of the 1970’s, 1980’s and early 1990’s wasn’t that long ago..
Why do we dabble with debt if it’s so bad? There are many reasons, but I believe it to be a lack of financial education and our attitude to our needs and wants. If no one ever told us debt was bad or educated us on financial wellbeing how are we to know? Debt has become a cultural default over time and the path of least resistance when deciding how to afford things we couldn’t otherwise afford. Governments, businesses and people all use debt so it might seem counter cultural to say debt is bad when you see everyone else using it. Debt is also big business. It wasn’t long ago the global financial system nearly imploded on the back of people, businesses and governments over exposure to debt. The 2008 Global Financial Crisis shook the world economy to it’s core. The rules we have around lending today were nonexistent in the mid noughties. Banks, governments and regulatory bodies were asleep at the wheel. A sudden and sharp withdrawal of global liquidity sent market valuations into freefall. The more debt held, the worse it was as negative equity quickly became a reality. That is many people were paying much more than what their home was worth as the market nearly halved. Many people and businesses got badly burned and some never recovered. It’s no surprise then that household debt in Ireland peaked during this time at nearly 120% of GDP. That is to say our household debt was 20% higher than the combined value of all goods and services produced in Ireland in 2010. This is why personal financial responsibility is fundamental to our financial wellbeing. Debt brings added financial risk into our lives. As they say, it’s not history that repeats itself, it’s human nature that does.
With such easy access to debt, it can feed our craving for instant gratification. Instant gratification is when we choose to forego long term benefits in favor of short-term pleasures. Why delay gratification when I can buy it now, is an entirely natural emotional response. Our impulse is to create a narrative in which we rationalize a bad idea into a good one, telling ourselves we can afford it, we deserve it. I’ve had a tough day, week, month, year. I work so hard, I’ve earned it. Sure, I can pay for it later. That new car feeling, new clothes, shoes, accessories, phone and vacation excitement. They feel good and appeal to our inner wants. When our wants are satisfied instantly there is an initial feel-good factor, but this quickly fades, and we are left with little appreciation or gratitude. We quickly move on to the next must have thing. We are beings driven on emotional impulses of pleasure. It is embedded deep in our psyche and it’s what marketing, media, social media, advertising and branding companies attempt to tap into as part of their campaign messages. This coupled with comparing ourselves to family, friends and even strangers. Trying to keep up with the Kardashians will leave us broke and in debt. Debt is the easy choice but it’s the equivalent of going backwards on our wealth journey.
When we start our first job we receive one of our biggest pay rises and our imaginations run wild with all the different things we can buy. Our lifestyle subsequently rises to spend what we earn. With each pay rise adding more money into our pockets, we naturally increase our spending to our new level of income. We then discover we can borrow more to purchase nicer things which we can pay for later. We get the thrill, excitement and joy from our added spending power and delay the pain of payment. We can end up buying things we don’t need with money we don’t have to impress people we don’t even like. Don’t get me wrong it’s nice to have nice things. What I have found though is that buying things brings momentary happiness. Many of the things that sustain happiness cannot be bought. Maybe it’s age but when I was younger, I cared a lot more about material things. As I’ve gotten older I’m less interested in material things and more interested in experiences, learning new things, enjoying time with family and friends, developing a successful business, giving back and so on. None of the top five regrets in episode 2 lamented material possessions. As Edmund Burke once said: ” If we command our wealth, we shall be rich and free. If our wealth commands us, we are poor indeed”. Debt is what will keep us poor if we allow it.
Delayed gratification or the path of most resistance is the opposite to instant gratification. When saving up for something we experience the time and effort spent to earn the funds required to make the purchase. The value we attach to our savings is higher due to the sacrifices we have had to make elsewhere. Having reached our savings goal some of us will think twice before spending the money. This hesitating is positive loss aversion. Saving wasn’t easy and took time to build, so we think twice before spending it. This hesitation usually increases the larger the amount is.
An example of how we sometimes mentally account for debt is when someone has savings of say €10,000 but has borrowings of €7,000. In my experience most folks do not want to use their savings to pay off the borrowings even though it is costing them money to continue the repayments. It makes no mathematical sense, but it feeds into a known bias called loss aversion. We don’t want to lose €7,000 in savings by paying off debt even though we will be paying an additional €1,500 in interest by keeping the debt. The loss of €7,000 in savings outweighs a saving of €1,500 in interest. Essentially, we value what we have comparatively more than we should.
There are a number of reasons we get into debt, but they broadly fall into three categories. Planned, unplanned, poor spending and saving habits. An example of planned debt is a mortgage, the less bad debt of bad debts and an asset that goes up in value long term. With each repayment our net worth will gradually increase over the long term. We plan by saving for a deposit, make sure we have our bank accounts as tidy as possible, have all our documentation in order, contact the broker or bank and complete the loan application. It is preferable to use as little debt as possible when purchasing a home but of course for many of us this is unrealistic. If we borrow €500,000 over 30 years with a 3% fixed interest rate, we will pay €258,883 in interest or over half the borrowed amount. In episode 2 we discussed our per hour income after tax. How many hours would we have to work, just to pay the interest alone?
Unplanned debt can vary widely from medical expenses, reduced income, car trouble, unemployment, home repairs, accidents & emergencies and so on. We can plan, for unplanned debt. We can save for it ahead of time. As mentioned previously in episode 3, a starter emergency fund of €1,000 and emergency fund of 3-6 months of expenses can be used to avoid going into debt when life happens.
A paycheck can be a destructive or constructive force in our wealth building journey. If we don’t know what our current lifestyle costs us, we will never truly know what we can afford. It is one of the big reasons we inadvertently slide into debt and remain there. Spending what we earn or more than we earn means we have little or no savings to rely on when financial surprises happen. Bad spending habits are as a result of poor money maturity. A written spending planner or budget can help uncover if we are spending more than we earn or spending what we earn. Those who know the true cost of their lifestyle spending and cannot afford it will ask themselves how can we afford it? Mapping out the savings required will reveal how much we really want it. What spending sacrifices will need to be made to save more or maybe we’ll boost income. What is the opportunity cost?
So, how do we get out of debt? We maintain minimum debt repayments while creating the ability to save by cutting spending or increasing income. Once we have created some savings capacity, we build our €1,000 starter emergency fund. We then list out all our debts. Write down type, amount outstanding and interest rate. This would also be a good opportunity to request a credit check. This can be requested through the Central Credit Register or Irish Credit Bureau. There are three methods we can use when paying off debt. These are:
The debt avalanche
The debt snowball or
The debt tsunami
The debt avalanche lists debts from highest interest rate to lowest interest rate. While maintaining the minimum debt repayment across all debts. Using our savings rate we pay down the debt with the highest interest rate first. Once the highest interest rate debt is cleared, we then use our savings rate and the repayment we would have made to the highest interest rate debt and apply it to the second highest interest rate debt. We repeat this process until we are debt free. This is the most efficient method mathematically from a cost and time saving perspective to become debt free.
The debt snowball lists debts from lowest to highest by outstanding balance, smallest amount first, largest amount last. The lowest debt gets paid off first and that repayment is redirected to the second lowest debt outstanding balance and so on and so on. Psychologically it is a win in terms of reducing the number of debts outstanding quickly and therefore encourages us to keep going. It will take longer and cost more but if we thrive off reducing the number of loans outstanding quickly, this is the debt repayment structure for you.
The debt tsunami lists the debts from highest to lowest based on emotional impact. So, a loan from a family member, friend or colleague which is causing us the most stress or anxiety would be paid off first and that repayment is redirected to the second highest emotional debt outstanding and so on and so on. From a financial perspective the debt avalanche is the clear winner. However not all money decisions make financial sense believe it or not. The right one is the one that works for you. Of course, we can chop and change across the three different methods depending on how our debts land. I would avoid borrowing from family, friends or colleagues if at all possible.
The above methods focus specifically on prioritizing debt repayments. There are other tools at our disposal that can super charge debt repayments. Increase our income, whether that be boosting income at work, extra shifts, a promotion, overtime, double jobbing, a side hustle or selling anything we own that gets us closer to being debt free. There may even be a time where you have to sell the very item you went into debt for. We can search the market to see if our interest rate is competitive and switch if it is favorable to do so. When it comes to credit cards some providers offer an interest free period, which can allow us some breathing room. Make sure to read the terms and conditions carefully. Debt consolidation is suggested as a way to manage debt better, but I believe it sweeps the real issue under the rug by extending the term and reducing the interest rate. The real issue being how the debt was accumulated in the first place. Sometimes debt consolidation can serve to appease the borrower and for more debt to be accumulated. When tackling nonmortgage debt, reducing or temporarily stopping saving, pension, or investment contributions is a good idea unless they are absolutely necessary. Remember the 8 step financial goals in episode 3. Support can be found at the Money Advice and Budgeting Service if you are struggling with unsustainable debt. You might have to negotiate a new repayment plan with the lender. Keep communication lines open and remember to seek help if we feel we are unable to handle it on our own. Another query I get from time to time is when an inheritance or windfall is received, whether we should pay off the mortgage or invest it. I believe we should pay off the mortgage, yes, even if it’s on a tracker. The reality is you wouldn’t borrow money to invest so why do it here. The piece of mind that being debt free allows is far more valuable than potential performance from an investment. There are no guarantees when it comes to investing but we can guarantee no more mortgage repayments. Paying down debt removes financial risk from our lives. Investing money that could be used to pay down debt only adds financial risk to our lives. No more mortgage repayments. Plus we can then redirect the monthly mortgage repayment to our pension, another investment or live a little more. Debt can be quickly accumulated but takes a long time to fix. When it comes to debt the odds can be stacked against you. It can take months, years and decades to pay off debt and it will require laser like focus. Bringing the debt needle back to zero will have only gotten us back to the start line from which to build wealth. Setbacks are inevitable but it’s critical to not allow ourselves revert to bad habits for too long. Once debt free it is important not to relapse and see it as an opportunity to spend ourselves into debt all over again. It happens all the time. The slate is wiped clean only for debt to be racked up again. We need to remain disciplined and replace bad habits with good ones.
In summary, debt is a headwind in our journey to building wealth. Personal finance is a zero-sum game. What we earn, what we spend, what we own and what we owe. Increasing income or reducing spending are our two options to tackling debt. There is no magic formula or quick fix. To become and stay debt free is an incredible achievement but does not happen overnight or without sacrifice.
This week’s book recommendations are The Total Money Makeover: A Proven Plan for Financial Fitness by Dave Ramsey. Dave has a no-nonsense approach to dealing with debt. And Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely. Are we making smart rational choices when it comes to money? Dan Ariely, an MIT behavioral economist explores human experiments which refute the common assumption that we behave in fundamentally rational ways. And The Dumb Things Smart People Do With Their Money: Thirteen Ways to Right Your Financial Wrongs by Jill Schlesinger. We all know one. A know it all, only they don’t. You don’t know what you don’t know. This book aims to highlight our emotional blind spots when it comes to money. This week’s movie recommendations are Rounders, Matt Damon plays a law school attending reformed gambler that returns to the tables to help a friend played by Edward Norton, pay off his gambling debt. And Uncut Gems, Adam Sandler plays a fast-talking New York City jeweler who risks it all to stay afloat. While the type of debts and therefore risks in both of these movies won’t be applicable to most of us, they are eye opening insights to the risks taken to get out of debt.
Link to Spotify podcast episode: https://open.spotify.com/episode/6rFOFdx8qZKD9pPI43Y5F9?si=755021cf3feb4b82
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s1-e5-debt/id1539630506?i=1000501664918
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