For example, a credit card might provide you with up to 1000 dollars in which to purchase things without having to use your own money. However, this credit must be paid back, often if you do so in a short enough time frame you do not need to pay any interest. The trouble is, credit card companies, like all banks, are designed around making money. So they choose to charge an interest rate and often fees for various services. Sometimes these are equitable, small fees. In my case, the last time I was used my credit card abroad, I was charged a small fee for the service of currency conversion. This seemed very reasonable. Other fees are designed around making the credit card companies money, such as late fees. The last time I looked, my credit card’s late fees were something like 35 dollars. These fees strongly encourage you to be careful with your finances and to keep close track of them.
Today I want to talk about how debt can affect your in the long and short term and what you should do about it. In many of the financial blogs I have read they describe some arbitrary numbers that look like this:
Debt: $20,000 (@ 6% Interest)
Mortgage: $300,000 (@ 4% Interest, 30 years, fixed)
From here they would talk about if you should put your money into investments, the mortgage, savings or pay off debt. They might then talk about an investment that would make 10% interest and discuss the pros and cons in investing. In my opinion, this sort of example is too simple. It doesn't even say if the income is gross (income before expenses, like taxes) or net (income after expense)! Instead, let’s talk about debt. Debt is not free money but rather someone else’s money you are borrowing for a fee, backed by a contract. The debt in the scenario above shows:
- That is nearly 40% of the gross income for a year is dedicated to debt.
- 20% of the income would be required to pay off the debt, to say nothing of the sizable mortgage. The scenario does not say if the debt will increase in interest, as most credit cards charge more in interest than that. Perhaps it’s student debt, but that is still a sizable sum.
- 17.2% of the income is going to the mortgage.
- The person appears not to have any savings.
- Maybe they have a 401K plan not shown, but they certainly don’t seem to have a safety net.
A 6 month plan is a plan that will allow you live at your current lifestyle for 6 months. Why that? First of all, it is easy to calculate, since all you need to do is look back at the last few months of expenses. If you don’t know how to do that, I suggest using financial management software such as Money Pig to assist you in the problem. Another reason is because 6 months may not be long enough, but you can always cut expenses, but once you have lost your job, you can’t increase your income. Now if you have a emergency, you can use the money saved up without the need for even more debt.
The alternate approach is to pay off your debt. This approach in the short term will save you more money, as you will not be paying interest on your debt. If you pay off that debt load and had an emergency, you could perhaps get more loans. This is a risk however, as some lenders will not be interested in you when you lack a job. However, this approach has two more big downfalls. The first is that you are still not learning the habit of saving. This habit is valuable and worth cultivating. The second problem is it might take you a long time to complete and you will not have that safety net for the entire time.
A third approach. Why not try a combination of the two approaches? I suggest that a 20% of your income go into savings, from the 401K, if you have it, to the emergency fund to private investing, with a bare minimum of 10% going to the emergency fund. I then recommend another 10% go into the debt, which would pay the debt off in a matter of years. Once the emergency fund is paid up, then I would put that money into paying the debt off. Once you are debt free (except for a mortgage), then and only then should you be debating various investment options.
Keep in mind, every situation needs to be custom tailored as there are always more complexities than can be captured in a single post.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investing advice and/or professional financial advice. Always consult with a licensed financial professional.