Everything You Wanted to Know About Debt: Keep Your Friends Close and Your Enemies Closer

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I locked eyes with the waiter, raised my hand, and pinched my fingers together for a short scribble in the air like I was following the random flight path of a fly. He nodded and approached the table shortly afterwards.

“Take your time. I’ll be back to collect it in a moment,” he said.

“How much?” asked Zack.

“$57.38.”

My slim jeans do not give up my wallet easily. I pull out a lustrous, royal blue card. I tuck it into the little black folder’s pocket and set it on the edge of the table, with the blue of the card sticking out. Zack’s eyes grow wide.

“Dad, can I get a credit card?”

(Today continues the series on debt. In the last post, I talked about how consumer debt levels are much riskier than a company’s debt levels and the mindset for getting out of debt. Today I will attempt to answer everything you wanted to know about debt.)

Zack’s experience seeing me pay for lunch is similar to the first time many children see debt in action. He thinks that credit cards are magical things that allow you to buy anything you want whenever you want. Easy now—many adults think the same thing. Many adults act like that $20k credit limit means that the dollars in their wallet increased by $20k. When I talk to people about their finances, most of the time I’m helping them figure out how to manage their debt.

Most of us don’t understand the basics of debt. It can feel like a scary hike through unknown woods. So let me give you a map to help you navigate your journey. Let’s start with the questions you were scared to ask.

Q&A

What is debt?

Debt is pulling forward your future earnings/income to buy what you couldn’t (or don’t want to) pay for upfront by chopping up that upfront cost and adding a fee for letting you spread it out (that’d be your interest rate).

You already know that if you buy $100 of groceries with debt, you either pay $100 when the credit card statement comes due or in installments with a fee, called your interest rate. So if the monthly minimum payment for that $100 is $10, you’ve reduced your future income by $10 a month until you’ve paid off that $100 and the associated fees. Your child only sees the “pay for upfront” side of this transaction, not the reduction thereafter of future income. No wonder they can’t wait to get their own credit card!

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Tip: Next time you’re out with your child and pay for something on your credit card, let them see how much it costs. Then, not too long after, either log into the credit card website’s transaction history or take the paper statement, and show them that specific charge. This is a good way to show them that the lunch (or whatever it is) wasn’t magically paid for but is deferred—it still exists until you pay it off.

Why does debt exist?

Contrary to belief, debt has been a beneficial invention—when used properly. Think of your diploma. If debt did not exist, then that diploma framed above your desk disappears. So does your life as you know it. Colleges need to collect the tuition within the school year or they can’t pay their professors. If you don’t have professors, you don’t have a college. Then you don’t have students willing to pay tuition and the whole business model collapses. So debt steps into the “tuition needed” vs. “tuition you can pay” gap, allowing you to pay that tuition and allowing colleges to operate.

If debt did not exist: Here you are fresh out of high school trying to save up $200,000* for 4 years college, in a job that pays what they pay non-college graduates with little work history. (I assume you’re saving for the full 4 years tuition now since you can’t work enough hours while in college to pay for years 2-4.)  How long would it take you to save that $200,000? Can you wait until you’re 60 to flip that tassel to the left?

Or can you wait until age 40 to buy a car or 75 to buy a house? A world without debt is not the world you want to live in. I was once at conference put on by either Lehman Brothers or some other failed bank where one of the speakers said something about how if the financial universe were a human body, debt (loans, bonds, alphabet soup derivatives like CLOs, CDOs, MBS, RMBS…) would be the entire body and equity (like stocks) would be a zit on its nose. In many ways, debt is the (sometimes) invisible force that shapes our economy.

So, it sounds like debt is a good thing? Then why does it feel so bad?

Debt is like sugar. In fact, take the quote below and apply it to debt:

“We actually need sugar; it’s our body’s preferred fuel,” says David Katz, MD, director of the Yale University Prevention Research Center. “But we eat too damn much of it.”

In the same way, naturally occurring sugar (like the kind in fruit and milk), is part of a normal diet. It’s when you add sweeteners that throws things out of balance. As I mentioned in my last post, the average American pays 406% more in interest than what the government thinks is safe for companies to pay. And companies generally have more financial negotiating power than the average American—it can sometimes raise prices and/or squeeze its vendors.

Debt. We use too damn much of it. And the high fructose corn syrup of debt is the credit card.

Can you tell me more about credit cards?

Anyone offering you debt (credit card, mortgage) is basically doing a risk transfer. Let’s use grocery stores as an example. In the case of credit cards, that means that Visa pays Whole Foods on your behalf, eliminating the risk that Whole Foods won’t get paid in exchange for a 2% or so fee. It makes everything faster so that you don’t need to go to the bank to get out cash every time you want to buy groceries, and Whole Foods doesn’t have to spend time making sure you have the ability to buy groceries. Also, credit card companies pay Whole Foods in a few days, so Whole Foods doesn’t need to wait long before the cash comes in to pay its employees or to stock its shelves with more strawberries and milk.

But credit card companies transfer risk onto themselves because you might not pay them back. They can’t just come and knock on your door to get that toy that you bought back. This is called unsecured debt because they do not have a claim (lien) on your assets. And because this is risky, they price in the chance of your not paying them back into your interest rate. This is why credit card rates are so high—the rate they offer you is basically how they feel about your ability to pay them back.

So this risk transfer is a fancy way to describe a 3-party game of hot potato where the risk potato passes from you to the grocery store, then then from the grocery store to the credit card company.  This part of the game goes on without a hitch. It’s the last toss that’s in question, where the credit card company will attempt to pass it to you, but it’s questionable whether you’re going to be holding the hot risk potato or they are when the buzzer sounds.  Credit card companies have sensitive hands, so if they’re left holding the hot risk potato, they pass it to a 4th player: the debt collector, who buys this credit card balance at a significant discount.

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Is there ever a good time to have debt?

To me, there are 2 instances when it’s okay to have debt:

  1. Used to smooth out your working capital: There’s a lag between when you need to pay for life expenses and when your employer pays you. I recommend keeping just 1 card that offers good rewards (there are ones that offer 1.75% cash back), and paying the balance in its entirety every month. So, unless it’s carefully planned, don’t buy anything you can’t pay off in 1 month.
  2. Used to finance an asset that will enhance your earnings. It may have pulled forward your future income to pay for it, but you used it on an asset to enhance those same earnings. (This is also why I think it’s important to know the various things you’d want to do before going to college so that you can weigh the tuition vs. salary).

A house can qualify under this criteria if it either is cheaper vs. renting (don’t forget to include the tax benefits) or you want to cap your housing expense in a location where rent and housing costs rise quickly. A car can also qualify under this criteria if you use to it get to work (or as work, in the case of Uber drivers) and the alternative is a lower paying but walkable job.

Wait, tell me again why debt can be bad?

Obvious way: We lose track. If we went all cash, we could only spend what we had in our wallet. You’re in line to get that $8 Chipotle burrito. You look at your wallet and there’s only $7. So now you need to go to the ATM or find a cheaper option. That gives you a natural governor for your spending and makes you always aware of how much you can spend. But with credit cards, we don’t really think about whether we have enough. All we do is swipe that card and tweet about what we just bought.

Hidden way: Debt often makes prices go up. If there’s no such thing as a mortgage, then house prices can’t be as high as they are now or else they’ll never trade. Additionally, priced into that burrito is the cost of paying Chipotle’s corporate debt (assuming it has any—I only use them as an example).

Bottom Line: We use debt to buy things that not only shrink our future cash flow, but fall in value (unless you think you can still get full price for those yoga pants you bought last year).

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So how do you get out of debt?

I saved the shortest answer, but longest process, for last. There are only 2 steps.

  1. Create a Budget. Easy.
  2. Stick to it. Not so easy.

Debt can be your friend or your enemy. If it’s your friend, hopefully this Q&A helped you get to know it and ways it can help you. If it’s your enemy, know it inside out, otherwise it can hurt you. Make a good budget and stick to it!

If you have any more questions, I’d love to hear from you via email or the comments section below! In the next post, I’ll show you how to make a budget (and if I have time, I’ll make it for you).


*Cost of rising tuition, why it’s been rising, at what point the benefits of college no longer outweigh not going to college…is a different matter I might visit in a future post.


 

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