Debt Reduction for the Willfully Stupid

Photo by: kainr

People get into debt in a variety of ways.  Some people have medical problems or other things that are largely beyond their control.  Others have simply traded their future earnings for current creature comforts.

While the ways in which people get into debt are varied, the ways out really aren’t.  A lot of people try to make debt reduction complicated.  It isn’t.  There are a few basic moves that will get you out of debt, but they’re predicated on being realistic, accepting that you’ve already had more fun than you’ve earned, and it’s time to redress the balance.  Even if your debt is the result of things beyond your control, here’s some basic advice for those who feel like it’s time to be realistic about how to get out.

Cut Your Expenses

So you have a certain standard of living you’d like to maintain?  Too bad.  When you’re in debt, every dollar you spend costs you that dollar, plus all the financing costs until all your debt is paid off.  Let’s take a simple example.  If you have a 20% APR credit card and it’s going to take you 3 years to pay down your debt, every dollar you spend is actually costing you over two dollars.  That’s without taking into account the fact that a penny saved is more valuable than a penny earned after taxes.  That five dollar burger is now going to cost you ten dollars.  While this ignores the effect of inflation, you get the point.  Putting that dollar towards debts was the better move.

Get a Second Job

Many people are very concerned about their free time.  If you have debt, you’ve already spent your future free time.  When you bought that flat screen TV on your credit card, you were trading your future free time for a TV.  Doesn’t seem like such a good trade now?  Imagine the impact of another twenty hours of work on your ability to pay off your debts.  Assuming you’re at least in the black and slowly paying down your debts, you can put every penny you make at your second job toward your debts.  While you’ll lose some free time, you’ll reduce the stress that all that debt is putting on you. (more…)

Is the Mortgage Crisis Over?

Photo by: respres

The mortgage crisis was clearly one of the dominating catalysts of the recent economic fiasco.  While many other factors contributed, this was one of the most visible and visceral to most people.  Thus many people, particularly homeowners, are now wondering whether they can breathe a sigh of relief.

How Did We Get Here

By now we’re largely aware of the underpinnings of this crisis.  Demand for securitized debt led to tremendous demand for mortgages.   This demand led to lowered lending standards, which led to tremendous demand for housing.   The demand for housing led to soaring housing prices.   When those with the least capacity to pay their loans, who incidentally had the most onerous terms to their loans, couldn’t make their house payments, the whole house of cards came down.  Foreclosures led to dropping housing prices, which led to more defaults, which continued the cycle.

The Subprime Crisis

During all of this we were told the mortgage crisis and the subprime crisis was one and the same.  Many people equate the end of the subprime problems with the end of our troubles in general.  This leads us to wonder if the subprime crisis is truly over.  Signs suggest that this is the case.1 After huge surges, the default rates on these loans have come down sharply, leading many to suggest that the crisis is over.  Of course, that depends on which crisis you’re discussing.

The Real Crisis

Subprime loans may very well be dropping in their defaults, however that statistic neither creates an increase in demand nor says anything about the impending wave of defaults in other types of mortgages. Falling home prices put everyone underwater increasing the chance of defaults across the board.  Although many people who bought houses during the boom bought them with subprime loans, many more did not. (more…)

1. Deutsche Bank – Subprime Chart [↩]

Debt and Moral Hazard

Photo by: Vinay Deep

For decades now the American approach to debt has been to worry about it later.  We’ve essentially kicked the problem down the road.  While some points in our history may have suggested somewhat higher debt levels, we’ve done nothing to reduce them in more booming times.  Ultimately we’ve just turned a blind eye to a growing problem and it may be too late. 

Many people are talking about moral hazard these days, but strangely they all seem to think it’s something that applies to someone else.  Bailouts of millionaire bankers strike us as outrageous, while we personally hold an absurd amount of debt.  Somehow the country got all screwed up without any of us being at fault. 

Our politicians seem to suggest that their opponents are the ones rewarding negative behavior and that they themselves would never commit such an act.  This doesn’t hold up to much scrutiny however.  Throughout the booms of the previous decades, neither Democrat nor Republican has ever used fiscal policy to “cool down” a boom.  Nor have they used any of the booms to reduce our debt to increase our capacity to deal with the next bust.

Clinton was just beginning to talk about reducing the debt when the Internet bubble burst.  Bush managed to go through a massive housing bubble while growing the national debt by over 4 trillion dollars.1  Government has simply never shown any discipline in managing its budgets.  Unfortunately, this is not only true of the government.

Short Term Myopia

Americans and people in general have a tendency to look at a very short sample space and assume that the results they’re seeing are meaningful.  Ten years is a long period of time in a human life, so if something has held true for the last decade, it must be true, the thinking goes.   Unfortunately those ten years are actually quite a short time in the life of an economy.

So many times in history we’ve been told that “things have changed.”  Something has fundamentally shifted and the old rules don’t apply anymore.  For the last decade, people watched their 401(k) accounts grow by double digit figures each year and they just came to assume that this was a sustainable result.  Similarly they’ve leveraged themselves to the hilt and assumed that since they’ve been able to sustain themselves with this massive debt they’d be able to do so in the future.  Sadly, this is an untenable ponzi scheme. (more…)

1. CBS News – Bush Administration Adds $4 Trillion To National Debt [↩]

Is the Debt Snowball an Atkins Diet?

Photo by: House of Sims

While I run the risk of alienating a lot of low-carbers out there, I’m choosing to use Atkins as an analogy because I think there are a few parallels between the diet and my reluctance to endorse the debt snowball approach that is currently en-vogue. Generally the accepted science on Atkins as of this writing is that while it is very effective at weight loss, the long term benefits are not entirely clear1. This largely equates to why I don’t advocate the debt snowball approach.
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1. “Atkins Diet Vindicated But Long-term Success Questionable.” Obesity, Fitness and Wellness Week — June 14, 2003: 25. [↩]

Investing Prerequisite #1: How To Deal With Debt

Photo by: SqueakyMarmot

This post is step 1 in our Investing Template.

Deciding when and how to pay off your debts is not a simple matter.  While it can be comforting to be debt-free, that may not always be the most financially expedient approach-nor is it the whole picture. Here are a few steps, including analyzing and paying off debt, that really make your money work FOR you.

Step One: The Basic Emergency Fund

The absolute first thing you need to have is something to pay for unforeseen events.  I personally recommend keeping this fund as small as possible at the beginning.  We’ll get to creating a larger cushion later, but right now the goal is simply to get enough money so that you’re covered if your car breaks down or something else untoward happens.  In fact, in some cases I’d recommend skipping this step altogether.  If you have friends or family you believe you can reliably rely on in case of an emergency, get right down to paying off any debts.  Once your debts are paid off, go on to creating an expanded emergency fund.

Step Two: Minimum Payments

Paying off your debts is one of the best investments you can make, but it isn’t always the best.  You need to take a lot of things into account to decide when and how to pay off your debts, and the analysis isn’t always simple.  One main rule is this:

Always Pay Your Minimums

You cannot possibly hope to match the interest rate you will be charged with late fees and penalties, so you have to pay at least the minimum to every debt you have.  So no matter what other options are open to you, do not let yourself be subjected to these kinds of charges.  If you cannot meet your minimum payments, it’s time for another job, or to sell some things.  Getting your head above water is a separate subject, but make sure to do it.

Step Three: Tax-Deferred Options

Now despite the allure of being debt-free, there are some rare occasions that your bottom line will be better served by contributing to your tax-deferred savings.  Quite simply, if your company matches your tax-deferred account at 50% or better, you may be better off contributing to that account.  This is of course only true up to the amount that they match. Do not contribute more than they match until your debts are all paid off.

For example, if my company will match up to 3% of my salary in my 401(k) at 100%, I am possibly better off making this contribution instead of paying off my debts.  I will make 100% return on that money put into my 401(k), while I will probably be charged 20% on the debts I leave unpaid.

Generally speaking however, unless your debt is relatively small compared to your income, or you are very secure that your income will continue, you are probably still better off just paying the debt.

Step Four: Pay Off Your Debts

There is no sense investing in anything when you have the option of paying off your debts.  The only debt you may want to carry is a house or a car, and even those are questionable.  Even beyond the dangers of high-interest debt, it simply provides a security blanket to have your debt cleared.  There are various approaches to paying off your debt, but get it done before you start investing your money elsewhere.  Moreover, when in doubt: pay off your debts sooner than later.