Have you considered what the true cost of your debt is? Are you leaving more money on the table than you thought?
Last month was debt month here at AtypicalFinance. This was in response to me paying off $26,000 in 11 months.
We learned how debt is like slavery and that there is no such thing as good debt for the average American. I also provided 11 proven strategies guaranteed to pay off your debt MUCH faster, as well as a few ways to turn your debt stress into motivation to paying it off.
But why? Why am I so passionate about living a debt free life?
Let’s ignore some things for a moment about debt. Let’s ignore the fact that debt is akin to slavery. Let’s put aside any feelings of stress from it that you may or may not have. Forget, for a moment, that it can limit your options of where you work or where you go.
Let’s get back down to the basics.
I’m sure you already know that debt has a cost associated with it in the form of interest. But the actual monetary cost of your debt is greater than you think. I’m passionate about this because you aren’t just losing money on any interest paid on your debt. You are losing money on investing as well.
I don’t want you to lose money! 😉
Opportunity cost is defined as the loss of potential gain from other alternatives when one alternative is chosen. This is usually used in the context of putting cash in savings rather than investing. By stashing money in an online savings account at 1% interest, you are losing out on the opportunity to make a higher interest rate by investing.
The opportunity cost is even greater with interest-bearing debt.
Why? Because you aren’t just missing out on the interest you could have made investing that money. You are going the opposite direction and paying interest instead of making it.
Your Financial Goals Get Farther Away
Think about it like this. You have a destination to get to so you get in your car to begin the drive. We’ll say the destination is 100 miles away. Instead of heading straight to your destination, you decide to start driving the opposite direction for 50 miles first.
Now it will take you 150 miles to get to your destination. Not only that, but you’ve lost more time driving 50 miles in the opposite direction first than if you started out with a 150-mile drive. You essentially are driving 200 miles to get to a destination that started out 100 miles away!
Let’s apply this to personal finance.
Your destination when it comes to finances is your financial freedom or any other financial goal you’ve set. This could also be standard retirement, early retirement, saving up for a downpayment on a house, a vacation, etc. When you are trying to build toward your financial goal, any interest bearing debt is taking you straight in the opposite direction.
Over the course of the past month, I’ve talked a little bit about necessary debt and unnecessary debt.
Necessary debt is the debt that is pretty much unavoidable unless you are making boo koo bucks. Think something along the lines of a mortgage payment. Sure, there are other ways to avoid a mortgage altogether, such as renting. At some point though, even though it may not be the investment that may think it is, it makes sense to buy a mortgage.
Unless you make enough to pay for your house in cash, or receive a large windfall, then the only way to own a home is to take our a mortgage. This is necessary debt.
Unnecessary debts are things like credit cards, personal loans, or car loans. Yes, there are, in fact, ways to avoid having a car payment for the rest of your life.
Unnecessary debt is the type of debt that will take you farther away from your goal.
I’ve had some experience with unnecessary debt. Because I’m such a Disney fanatic, I go to Disney World a lot. Probably too much.
At times, I’ve taken used credit cards to finance a couple of different trips. This is the epitome of unnecessary debt. Did I need to go to Disney World? Of course I did!
I mean…NO! I didn’t need to go to Disney World. But I did. And I used unnecessary debt to pay for it. Don’t be like me.
Luckily, those were interest free credit cards I used. However, it still kept me from getting to my financial goals faster. There is always a cost involved.
The True Cost
So how do you figure out the true cost of your debt?
In order to find the true cost of your debt, you have to take the interest rate you are paying, and add it to the interest rate you could be making.
For example, if you are paying a debt with a 4% interest rate, and you could be making an average of 4% in the long run by investing that money instead, your true cost would be an 8% interest rate. Not only are you paying out 4% to someone else, but you are losing the opportunity to make 4% as well.
As you can see, it’s a much higher cost of debt than just the 4% you are paying to someone else.
Now, what if you have some debt, can afford the monthly payment, and decide to start investing money instead of paying down your debt? There is definitely still a cost of your debt involved in that situation.
For example, if you have a low interest personal loan at 5% interest, and are investing with an average return of 8%, you are essentially losing 5% of your interest gained. This means that you are only earning 3%! Still more than a savings account, but much less than the full 8% if you didn’t have that debt.
A true apples to apples comparison is beyond the scope of this blog post (and would include way too many variables). However, if you are in this situation and want to figure out the actual cost, you can take the actual dollar amount earned from your investments and subtract the interest amount you paid from what you earned. This will give you the cost of you holding on to your debt.
Don’t forget about the opportunity cost of your monthly payment going to debt rather than investing. This is getting ugly now!
The more debt you acquire, the greater the true cost grows, and the farther it can take you away from your goals.
3 Tips to Avoid Unnecessary Debt
So, practically speaking, the best way to avoid lengthening your trip to your financial goal is to avoid unnecessary debt. I realize, though, that taking on unnecessary is unavoidable.
That being said, I wanted to give you some tips that will help you avoid having to take on unnecessary debt.
Live Below Your Means Consistently
I think we’ve all lived below our means at some point. The problem we face is that it’s not consistent. If you hit a milestone in paying off your debt and decide to reward yourself, it is hard to go back and continue paying off the rest of your debt. I think that’s just human nature.
What’s one of the best ways to live below your means? Only spend money on what you value! If you are not spending money on things of no consequence to you, then it is much easier to live below your means and doing it consistently.
Just like with health, being consistent is key. Living a healthy lifestyle is just that—it’s a lifestyle. It’s a way of life.
Living below your means is the same way. If you can train yourself to to where living below your means is normal, it’s much easier to maintain. Then, when you reward yourself or splurge, that’s an atypical thing and it’s easy to go back to the norm of living below your means.
Oh, and about splurging…
Never Spend More Than You Make
When you do splurge, don’t go overboard. Splurging involves spending money that you have to spend. The keyword there is “have.”
Don’t spend what you don’t have already.
This seems like a simple thing to do, but it can be difficult if you don’t have a handle on where your money is going. In order to accomplish this, track your spending. I know that not every kind of budgeting is right for every person, but you want to make sure you are tracking enough to not spend more than you’re bringing in. This is the quickest way to having unnecessary debt.
Even if you spend more than you make for just one month (let’s face it, we’ve all been there), that means you have you to compensate next month. This may take money directly from your savings or debt snowball, or it may mean being close to not having enough the following month.
It’s not a good feeling.
But what if something happens? Then…
If You Absolutely Have to, Use an Interest-Free Loan
I wanted to include this in here because, like I said, sometimes something happens and taking on unnecessary debt is unavoidable. So if you have to, use a credit card or loan with a promotional 0% APR (not for a Disney World trip!). Then make sure you are dividing your payments up into equal monthly payments so the balance is paid off by the time the promo period is up.
Let’s go back to our “driving to your destination” analogy. Again, your destination originally starts out at 100 miles away. Taking out an interest-bearing loan or using a credit card with a standard interest rate is like driving 50 miles in the other direction first and then heading to your destination.
The destination is now 200 miles worth of driving. Using an interest-free loan essentially makes it so you start at the 150 mile mark instead of driving in the wrong direction first. It still sets you back from reaching your goal, it just doesn’t do it as much.
I want to stress that this is for emergencies only. It doesn’t count if you “absolutely have to” buy that new TV that you saw at Best Buy. Or go to Disney World.
Speaking of Disney World…
Bonus tip: DON’T GO TO DISNEY WORLD 😉
This may sound like a joke due to my level of Disney fandom. However, I’m only half joking about this one.
Remember how I said that I would go to Disney World by using credit cards and a Disney Vacation Club Loan at more than 11%? My Disney trip coming up here in a week is the first time we are paying for it outright. As in, not taking on any debt to pay for it. And you know what?
It feels amazing.
I’m not going to have this balance that I’ll be staring at for months to over a year down the line.
I feel like I just graduated from Disneyholics Anonymous. Disney has this way of sucking you in and making you want to say “take my money.” So only go if you can afford to. 😉
It’s clear that even when we take away all of the baggage that debt brings with it, how it messes with our mind, and how it can limit our options for what we want to do with our lives, even if we’re only looking at the monetary aspects, there is a clear cost to having it.
Remember, in order to figure out the true cost of your debt, simply add the interest rate of your debt to the average interest rate of what you would have invested in. At the same time, if you have low interest debt and are investing your money, you can subtract your debt interest from what you are making in interest on your investments.
What are some other costs of holding debt can you think of? Have you ever spent money you don’t have on a trip you need…er…don’t need to take?
All confessions will be kept confidential and only seen my those who have internet access. 🙂