Everything About Debt

TL;DR

Debt is “renting” money from other people, using the terms of a loan to specify how much the rent will cost.

There are many things that debt companies don’t want you to believe:

  1. Nothing is ever “good” to go into debt for, though some things are worth the new obligation if you can make more money long-term.
  2. The interest payments from debt are never worth the incentives from debt holders.
  3. Investing does not require a good credit score.

The only way to morally escape debt is to overpay every month.

What is debt?

Debt is essentially “renting” money:
  1. A borrower asks a lender for money and gives something as “collateral” for it (e.g., borrowing $1,000 for a ring worth $400).
  2. The lender gives that amount (“principal”) with a specified interest rate (e.g., 10%) as “rent” (“interest”).
  3. At a specified interval (usually monthly), the lender calculates the remaining principal and interest for the borrower and asks for a monthly payment.
  4. As the borrower pays off the principal, the interest amount goes down, which makes either the lender’s minimum payment go down or the next payment made of more principal than before.
  5. Since monthly payments are typically the same across the life of the loan, most of the early payment goes straight to interest.

A. A loan contract puts several things in writing:
  1. The loan amount
  2. The interest rate
  3. The frequency of the interest rate being calculated against the remaining balance
  4. The minimum payment the borrower has to make

B. The lender expects a minimum payment:
  1. Not paying or underpaying will often incur late fees.
  2. Any overpaid amount goes straight to the principal.
  3. The remaining balance is re-amortized.

C. Loans with higher balances often stagger payments toward interest:
  1. The lender assumes the borrower will make minimum payments and calculates all future interest (e.g., $1000 at 10% across 65 months is $299).
  2. Most of the first payments go almost entirely to interest (e.g., (e.g., in Month 1, a $20 payment sends $19 to interest and $1 to principal).
  3. Overpayment goes to principal, assuming the loan hadn’t specified different terms (in Month 2, a $30 payment sends $19 to interest and $11 to principal).
  4. Near the end of the loan’s life, the principal is a larger portion of the payment (in Month 40, a $20 payment will send $4 to interest and $16 to principal).
  5. This staggered payment ratio makes minimum loan payments dramatically pricier than paying them off early.

Debt companies market lies

They make trillions on debt, so they spend billions to advertise.

These lies have been around for decades, and refuting them can often be offensive:
  • Consumer debt is always a product designed to fulfill instant gratification, no matter how it’s pitched.
  • A household that makes routine credit card payments as a type of “bill payment” is in a state of financial crisis.
  • Owning a credit card creates an inherent risk, not an inherent security.

A. Nothing is ever “good” to go into debt for

For thousands of years until the 1960s, society has seen debt as universally bad.

The marketing around debt vehicles now implies that some debts are “good”.

Debt guarantees increased stress and risk proportional to the amount the person is borrowing.

Loan consolidation is bad for several reasons:
  1. Debt consolidations usually roll lower-interest loans into them.
  2. Borrowing from A to pay off B changes the debt owner and can create unforeseen consequences.
  3. Smaller debt payments compound more interest.
  4. A freed-up line of credit feels convenient to use.
  5. Paying off one colossal loan is more daunting than many smaller loans

Never cosign a loan:
  • If someone needs a cosigner, the lender deems that person unlikely to pay.
  • If they don’t pay for any reason whatsoever, collectors will chase you down.

Lenders market financing (a sophisticated term for debt) as a tool for “necessary” purchases:
  • Companies make much more money from borrowers than straight purchasers.
  • Borrowing against any item that depreciates over time (e.g., furniture, mattresses, luxury items) creates additional risk.
  • Sell and avoid buying anything that takes more than 18–24 months to pay off.

Automobiles don’t need financing to purchase:
  • New vehicles lose about 60% of their value in the first four years.
  • Most self-made millionaires drive 5- to 15-year-old used cars.

Payday loans are especially egregious, and have extortionate fees and insane rates.

Only three forms of debt are ever legitimately a good idea:
  1. Home loans:
    • The mortgage should be within 25–50% of your income.
    • The housing market shouldn’t be overly inflated.
    • Research before considering.
  2. Education:
  3. Business loans:
    • You should have a good business plan before you start asking for money, as well as a plan for what to do if you fail.
    • Create the business as a limited liability organization, not as an extension of your estate<./li>

B. Incentives aren’t worth the cost

Lenders sweeten their debt product sales with rewards programs and incentives:
  • T-shirts and coffee mugs are worth far less than one credit card payment.

Scientifically, the increased degree of emotional separation from our money motivates us to spend more with credit cards.

Accumulating points isn’t an investment or particularly savvy:
  • Reward points often expire before they’re used.
  • Many rewards program points have limits and expiration dates for using them.
  • Years of diligent points accumulation can be invalidated by a few months of interest payments, even with double or triple points.
  • Donating points to charity is another incentive to attach positive feelings to debt.
  • Cashback is far less useful than cash.

Low card fees are usually not worth it:
  • 0% interest forms a habit of using a credit card as a bank account for 12–18 months.
  • No annual fees for the first year implies subsequent years won’t have fees.

Online purchases don’t need credit cards:
  • Bank debit cards are as fraud-protected and accepted as credit cards, and typically have the same payment processors.
  • Many third-party payment processors (e.g., Square) work just as well as debt vehicles.

C. Credit scores aren’t necessary for investment

Credit reports pull data from your past 7–10 years:
  • Demographic information:
    • Name and any other names
    • Phone numbers
    • Birthdate
    • Current and past addresses (which can be adversely affected by frequently moving or inaccurately filing with the government)
  • 35% — past payment history:
    • Any bankruptcies or judgments in the past ten years
    • Bank overdrafts
    • Missing or on-time bill payments
  • 30% — debt level:
    • Credit accounts and their limits
    • Unused credit accounts that are left open
    • A manageable percentage of your income going to payments is considered best
    • If you have no debt, closing accounts won’t affect your utilization score.
  • 15% — length of your credit history (longer loan histories look better)
  • 10% — new credit:
    • Credit cards, large purchases, mobile phone and rent contracts, mortgages
    • Personal loans
    • How frequently you apply for credit and where (less is better)
  • 10% — the types of credit, with any financial associates and bank details (fewer banks are better)

3 different bureaus calculate your credit scores (Equifax, Experian, TransUnion):
  • There are technically three credit scores that come from small variations in data capture.
  • Credit scores have no bearing on financial success.
  • The only thing credit scores help with is acquiring more debt, but the information is often used for other purposes involving financial commitments:
    • Renting an apartment.
    • Getting insurance.
    • Employers use credit reports without the credit portion as a de facto background check.
  • Scoring agencies compile the three different bureaus’ data into reports:
    • The two most popular reports are the FICO Score and VantageScore.
    • You can get free quarterly reports from all the agencies with a free login.

A credit score is a measurement of how much you use and manage debt:
  • Credit scores have no bearing on financial success.
  • The only thing credit scores help with is acquiring more debt.

Getting a high credit score is easy:
  1. Only have 1 credit card that reports to all 3 bureaus.
  2. Accrue less than 10% on that credit card routinely (e.g., refueling gasoline).
  3. Pay off the entire balance twice a month
  4. If you’re ever performing multiple hard inquiries (e.g., mortgage shopping), do it within a 14-day window to make it register as one hard check.

In summary, debt isn’t a financial tool

If you want to build wealth, stop seeing debt as an acceptable way of life.

Debt is either a bad idea or a necessary evil:
  • Every sustaining millionaire believes debt is financial slavery.
  • Don’t purchase extra insurance on a rental car (unknown risk) with a credit card (known risk).

Most large organizations make more money on debt than the actual product:
  • Just about every organization that sells things at scale, from cars to airlines, makes more income from servicing debt instruments than from the products themselves.
  • Beyond the risks to yourself, getting products with debt perpetuates the cycle and allows them to make increasingly inferior products in response.

Escaping debt

The only way to escape debt is to overpay every month:
  1. Make an additional payment on top of the minimum one.
  2. Round payments up to larger amounts.
  3. Make a significant payment with every windfall (e.g., a pay raise or bonus).
  4. If you know your payment will be late, call the creditor before the due date to get some forgiveness from late fees.

Debt collectors are unscrupulous:
  • The collector’s job isn’t to be your friend or help you out of your situation.
  • Their job is to get the money you owe.
  • Debt collectors try to induce strong reactions of fear or anger to get a payment.
  • They often aren’t aware of whether you made payments, and simply see a name and balance owed.
  • If you don’t pay them, your credit score will still have a hit (if applicable), but you’re among a vast majority of non-compliant debtors.

You do have some rights as a borrower

Lenders are supposed to go through a “dunning” process, where they start with gentle reminders, then move on to threatening letters and phone calls, and may even visit your home.

Unless the lender is the government or has another contractual connection with you, a creditor can only garnish your wages or take money from your account if they sue you and win.

You don’t legally owe anything to any debt collector until the moment you’ve made any payment for it.

Your rights include demanding they stop calling or harassing you at work or any time between 9 p.m. and 8 a.m. unless you give them permission.

Your rights also include demanding they stop all contact with you, except to notify that they’re suing you:
  • Stopping contact halts any chance of a favorable negotiation.
  • If a creditor can’t negotiate, they’re more likely to sue.
  • If they sue, they’ll likely win because you legitimately owe them money.

The only way to fight debt is with a workable budget.

This page is Part 2 of my Managing Money series. Part 1 was Why Money Management Matters.