This guest post is by Roshawn Watson who writes at Watson Inc on eliminating debt, investing money, and building wealth. Get his free eBook Your Foundation to Wealth by signing up for his email updates (no spam I promise). Get his RSS feed and connect with him on Twitter @roshawnwatson too.
Debt is one of the most aggressively marketed products in the world. It has permeated nearly every aspect of our lives. Even many churches are willing to accept offerings via credit cards, and Monopoly TM accepts credit card branding in their games.
The primary consequence is that debt is so ingrained into our culture that it hard for many to even conceive of purchasing a car or going to school without a loan. Unfortunately, consumer debts (i.e. student loans, credit cards, and car loans) such as these are exactly the worse kinds of debt to get into. These debts are designed to ensnare consumers into lifetimes of leveraged consumption.
Working for the Banks
If you are indebted to someone, with every payment you are increasing your lender’s wealth. Your debt is his or her asset. The longer you are paying it, the greater his or her return on investment. However, are you getting richer? Sadly, in many cases, the answer is no.
Let’s just look at the average American. The average credit card balance in America is nearly $10,700 ($200 monthly) with an interest rate in the mid to high teens. The typical car note is nearly $500 monthly. A standard student loan payment is about $250 per month. Of course, the list goes on.
Excluding the costs of necessities, such as food, shelter, transportation, and utilities, many Americans are already committed to paying at least $950 a month! It’s no wonder so many people feel trapped, they are literally working for the banks.
Imagine if these payments were converted into investments. If you received a very conservative return (7%), $950 could grow into a very respectable $2.5 million over a typical working life. However, instead of putting that $950 towards your financial freedom, it goes towards funding someone else’s financial independence. The price of debt is simply too great.
Debt equals bondage.
Pain of Paying Cash
Additionally, numerous studies have now repeated demonstrated that consumers who regularly use plastic for their purchases spend between 12-50% more (depending on the venue) than their cash-paying counterparts.
This phenomenon is known as the pain of paying cash. It is believed that direct loss of money causes our subconscious minds pain, so in an attempt to minimize the damage, we spend less. Thus, knowing that the money is coming out of our accounts serves as a motivator for us to spend less. By purchasing items on credit, there is a disconnect between purchasing and paying. With the financial pain is delayed to the end of the month, such as when one receives his or her monthly credit card statement, there is less motivation to curtail spending.
Also, by paying cash, you can get some phenomenal deals. I typically use this technique when purchasing cars. For example, I was able to negotiate the cost of my first car down 40% by telling the dealer that I was paying with cash. GM didn’t care that I was still a teenager or was at the dealership alone. All they cared about was that I had access to those greenbacks right then and was willing to take their gently used car off of their new car lot. I have used this strategy multiple times now. By having cash on hand, many buyers can gain the upper hand during negotiations and motivate sellers to accept their terms, provided that the terms are reasonable.
More than Just Money
In actuality, my criticism of debt goes well beyond money. At the root, it is really more about how we have been conditioned to think that the only way to solve our problems is through debt. In essence, the FICO score becomes our provider. It’s form of deification. Debt becomes our god! Financial guru Dave Ramsey says it this way: Do you worship at the altar of the great FICO? Before you answer that, consider this: if the only way you can see yourself living a comfortable life involves using consumer debt, then it is likely that you will always be in bondage to the banks. If you think you can or think you cannot, you are right in both cases.
Along the same line of thought, by keeping debt as an option to solve our problems, we often remove our ambition to solve them through other alternatives. For example, Henry Ford once commented that debt is the lazy man’s method to purchase items. Don’t diminish your ingenuity by settling for the “easy” way out.
Trust me when I say that when someone offers you credit, he or she is not giving you a gift.
Cash Back Bonuses
Nonetheless, some people are completely comfortable with using debt. Some people may even believe that they are getting over on Discover. For example, a common argument is I only use my credit cards for the cash back bonuses. I pay it off every month. The problem here is that that you are paying more for your items typically (see pain of paying cash). In the event of a job loss or sickness, do you have enough cushion via an emergency fund and non-retirement investments to weather an economic storm? Unfortunately, for many people the answer is no. The $50-$400 cash back bonuses aren’t enough to continue playing with snakes in my book, but that’s a personal decision.
The Big Myth About Credit
Lastly, people often say that their reliance on credit is to maintain or improve their standard of living. Ironically, they don’t realize that using credit decreases their standard of living. Let’s say you make $50,000 a year. This means your net (take home) pay is approximately $3125 per month (assuming 25% tax bracket).
Now if you are debt-free excluding your home, that means you likely have enough room in your budget to fund retirement and education funds, pay for reasonable housing, have fun, and give. However, if $950 of that $3125 is already committed to your creditors, the same income that had some flexibility (for someone who is debt-free) can become too rigid to gain much financial traction.
Thus, the person in debt has a decreased standard of living compared to someone who makes exactly the same income but has no debt. Additionally, the debt-free individual doesn’t have to deal with the stress of being in debt and has likely limited his or her monthly financial obligations.
In aggregate, debt makes arrogant assumptions about the future. It obligates tomorrow’s income today. Don’t mortgage your life and your family’s destiny for a new Toyota Camry. No car, dress, or Ivy League education is worth your financial freedom. After all, nothing is more precious than freedom.