Chapter 7: Other People’s Money?

Rub Squeers: “Can I borrow a dollar?”

Sully: “Nope. You can borrow a jelly doughnut, though.”

Rub Squeers: “You can't borrow a jelly doughnut. Once you eat it, it's gone.”

Sully: “Once you borrow a dollar, it's gone. I'd rather buy you a jelly doughnut.”

– Nobody’s Fool (1994)

We are constantly tempted to borrow: credit card offers, home-equity loans, zero-percent financing, layaway offers, don’t-pay-until-next-year deals, easy overdraft protection, payday loans, accelerated tax refunds, rent-to-own deals…the list goes on. What do these have in common? They are all debt.

Wall Street has a saying that debt is “other people’s money.” Wrong! Every dollar you borrow is a dollar you have to pay back. Debt is money borrowed from your future self that you are spending today.

Recall our discussion of human capital from Chapter 2: your lifetime earnings are finite. In our simple example there was $36,000 to spend each year. What happens if you take out a five-year car loan for $20,000 at “zero percent financing?” You only have $32,000 left to spend in the following five years because you’ve “pre-spent” $4,000 a year.

I could fill the page with numbers about the crushing debt load on American households from student loans, credit card debt, car loans, personal loans, medical debt, and many others. I’m not going to. You already know whether you are part of these statistics. If you are, getting out of debt should be a key goal for you.

Debt Basics

Debt is such an important topic that we need to get a little technical. First let’s define some terms:

• A loan is money borrowed, usually for a fixed period. Mortgages, student loans, and car loans are examples of loans. A line of credit, also known as a revolving credit line, is an amount that you have available to borrow, up to a limit. Credit cards, home equity lines of credit (HELOCs), bank overdraft protection are lines of credit. Once you borrow from a line of credit you have a loan.

• Principal is the amount borrowed. With most debt you pay a little bit of principal back with each payment. This is called amortization. Sometimes you pay all the principal at the end in a single “balloon” payment.

• Interest is an amount you pay for the privilege of borrowing. It’s common to make monthly payments of interest and some principal amortization. Interest is calculated by multiplying an interest rate times the amount of principal outstanding at the beginning of the month. The interest rate is often expressed as an “annual percentage rate” or APR. For monthly payments you divide this rate by twelve.

• Fixed rate debt has one interest rate for the entire term of the loan. With adjustable or floating rate debt the interest rate can change periodically.

• Secured debt is debt backed or “secured” by an asset. The asset is known as collateral. For example, a mortgage is debt secured by real estate, like your house. If you miss payments, the lender can foreclose (take your house). Auto loans are backed by a car. The lender can repossess (“repo”) the car if you fail to pay.

• Unsecured debt is only backed by your promise to repay. Lenders can come after you for repayment, but they can’t just take your stuff. The interest rate on unsecured debt generally is much higher than on secured debt.

• Co-signers are people who sign the loan documents and agree to pay if the borrower doesn’t. They are on the hook just as much as a borrower. Do not co-sign a loan lightly, and not at all if you don’t have the money to repay the debt.

Interest rates change all the time. Here are some typical rates (APRs) as I’m writing this:

Type of Loan	APR [10]
30-Year Fixed Rate Mortgage	3.88%
15-Year Fixed Rate Mortgage	3.22%
5-Year Adjustable-Rate Mortgage (ARM)	3.28%
48-Month New Car Loan	4.56%
Federal Undergraduate Student Loans	4.53%
Federal Graduate Student Loans	6.08%
Credit Card	17.55%
Credit Card Penalty Rate	29.99%
Payday Loan (borrow $200, pay back $235 in two weeks)	458.86%

Debt Mind-Games

Banks and other retailers play mental tricks to get you to borrow. Here are some to watch out for.

Size-of-Payment Ploys

One of the most common ploys lenders use is to focus on the size of the payment. This is a terrible way to look at debt. Here is how it works. A car dealer will ask you, “How much can you afford a month?” They’ll offer you a four-year, $10,000 loan with a 5% APR, which will cost you $230.30 a month. You balk. “Too much? How about I save you $40 bucks a month and make the payment $188.71? We’ll just make it a five-year loan. Sign here...”

You see what happened there? Multiply the payments times the number of months. With the four-year loan you pay back $11,054; with the five-year loan $11,323. Instead of “saving you $40 bucks a month” the dealer made an extra $269. Always know the total you have to pay back, including interest. This should be disclosed. If it isn’t, ask.

Another size-of-payment trick is the “minimum payment” on credit card bills. This is how lenders get around talking about ridiculously high interest rates. Here is an example from an actual recent credit card bill. The statement balance was $1,990. The minimum payment the bank wanted was $35. “No problem. I can afford $35. This isn’t so bad.”

But the bill also includes this (required) disclosure: “If you make no additional charges using this card and each month you pay only the minimum payment you will pay off the balance shown on this statement in about 8 years and you will end up paying an estimated total of $3,579.” Do the math. The bank makes $1,589 for lending me $1,990! That’s what happens with an APR of 17.24% (which I had to find in the small print at the end of the statement.) Always know your APR.

Things get downright criminal with very short-term loans, such as the payday loan example in the table. You “only” pay $35 to get $200 to tide you over for two weeks. Then here is what happens. You get your next paycheck and pay back $235. But because you just repaid the loan, you’re short again. Borrow another $200, and the cycle repeats. After a year, you will have paid $972 in interest because of a one-time need to borrow $200. That’s called a “debt trap,” and it’s why payday loans are illegal in many states.

During grad school, I had a job at a little shop in Brooklyn that was always in a cash crunch. Every Friday night, “Tony” would stop by after closing to collect his cash. I wonder whether he did as well as these payday lenders.

Discount Hooks

Ever go into a store to buy something and have the cashier offer a big discount right then and there if you sign up for a store credit card? It can be hard to resist these “hooks.” But once you have signed up, the retailer has won. You are now more likely to direct some of your dollars to this store, especially when you start getting a barrage of “member sales” and “special deals.” It also makes it easy to run up debt balances. If you succumb to many of these offers, it becomes harder and harder to keep track of total debt because it is all broken up across balances on many different store cards.

Zero Percent Offers

It gets uglier. Be careful when a store or credit card tempts you with “zero percent” financing. These are often “deferred interest” offers, which require you to pay off the balance within a certain time period. Which is fine if you meet the deadline. But in real life, stuff happens. Perhaps you don’t have the money one month or just forget to make a payment. If that happens, you risk being charged a sky-high interest rate retroactively. Example: you buy a $1,000 washer on a twelve-month, 0% deferred interest offer. You diligently pay $83 a month but forget to make one payment on time. All of a sudden, instead of 0% you’re charged 29.99% interest and owe an extra $140 on your washer. [11]

Another ploy by credit card companies is to tempt you with “0% balance transfers.” They want you to switch cards and move your debt to them. Dig a bit deeper into these offers and you find that you’ll be charged 3% or more just to make the transfer. If you have a balance where you are paying a high APR this may actually be a good deal, but it is not zero.

You can “game” these offers to your advantage, but the companies have figured out that many people will be confused, forgetful, or too financially stretched to pull it off. If you decide to play this game, be very diligent and understand the details in the fine print.

Debt to Avoid

Credit Cards

The ideal credit card discussion is short: pay off the entire statement balance by the due date every month. Every month. Every card. Fini. Do this, and the APR on the card doesn’t matter. You will not owe any interest. Instead, you get to use the bank’s money for free from the date of each charge to the due date on the statement. But miss the due date by one day or pay one dollar less than the statement balance and you owe interest starting the date of the charge. Plus a hefty late charge for any payments past the due date.

Credit cards are, therefore, a boon to people who charge only what they can pay off, but poison for those who carry a balance or forget to make payments on time.

If you have arranged your spending according to the 50-30-20 rule (see Chapter 5 for a refresher), you are much more likely to be in the first group. You can use your card strategically to pay bills and accumulate reward points without ever paying a finance charge.

If you’re in the second group, you need to make changes. Some of these may sound silly, but you have to find a way to not use the card at all or pay it off.

• Stop carrying the card

• Don’t “auto-pay” any bills from the card (substitute your debit card)

• Put the card in a place where it is difficult to access

• Remove the card from any sites where it is saved as a payment method (e.g., Amazon)

• Disconnect the card from mobile wallets and payment apps

Debt to Buy a (New) Car

Buying a car is a significant financial commitment. Go ahead and drool over Ecoboost turbocharged engines and Moonlight Blue Metallic paint. But also crunch some numbers. Most importantly, take time to reflect what is important to you. Then keep in mind the following.

One: buying a new car is a dumb financial move. The average new car loses 61% of its value in five years. [12] That means a $30,000 car will be worth $11,700 after five years. Still people do it. I’ve done it myself. I'm a car guy…I get it. But it’s not worth digging yourself into a financial hole for.

Two: Buying used saves you money. A new car will be a used car immediately when you drive it off the lot. If you want a newer model, buy one that is a year or two old and save thousands.

Three: Spend time figuring out how much car you can afford. Go back to the 50-30-20 rule and figure out your transportation budget.

If you don’t need a car, consider using public transportation, biking, or other alternatives. Use short-term rentals such as Zipcar for when you want to get out of town on weekends. Be like a European. It’s sexy and you’ll save a lot of money.

If you absolutely need a car, crunch the numbers. Your car payment plus all the other costs of ownership should fit in the 50% “must-have” spending bucket. Estimate how many miles you'll drive a year and the cost of gas for different models. Get quotes from insurance companies, research reliability data, and get typical repair costs for the cars you are considering. Then look at your budget. For example, say your transportation budget is 10%. In our earlier example, that comes to roughly $400. Say half of that goes to insurance, gas, etc. That leaves $200 a month to pay for the actual car.

Four: Don’t take out a car loan for more than thirty-six months. Five, six, and even seven-year loans are increasingly common, and they are a trap. [13] The longer the loan, the greater the risk of having “negative equity” in your car, i.e., owing more on the loan than the car is worth. These are “size of payment” ploys designed to make you buy more car than you can afford. Also, if you don’t think you want a used car today, what makes you think you’ll want one in three years. Your new car will be three years old, and you'll still owe two to four years on your loan.

Back to our example… If you have $200 a month available for thirty-six months, you can afford a car costing about $6,700. This is not unreasonable—very solid used cars can be had for this amount and even less. The best way to achieve this is to save up that amount and pay cash. But even if you have to borrow some, it is now a reasonable debt.

Five and finally: Leasing is debt. When you lease a car, you commit to making monthly payments from your future income. And at the end, you own nothing. You return the car to the dealer. It's another “size of payment” game: the payments can be lower because you only pay to use a car for some years. (Basically, you are paying for the depreciation of the car while you use it.) That said, leasing may be right for you if want to permanently devote a portion of your monthly budget to car payments and drive a new one every few years. Make sure your lease term is shorter than the warranty on the car so you're not on the hook for any major repairs. For more on the pros and cons of leasing see this article in Consumer Reports.