Bad Debt and Quicksand

I always thought that quicksand was going be a much bigger problem than it turned out to be. You watch cartoons and quicksand is like the third biggest thing you have to worry about behind actual sticks of dynamite and giant anvils falling on you from the sky. As I got older, not only have I never stepped in quicksand, I never even heard about it. -Comedian John Mulany

While we don’t have to deal with our childhood fears of actual quicksand being an issue, we do have to deal with another type of quicksand, bad debt. Bad debt shares many of the same attributes of quicksand. They both can seemingly come out of nowhere and trap you, both are difficult to get out of, and the only way to escape is by remaining calm and escaping slow and progressively.

There are a few distinct traits associated with bad debt. The four things immediately come to my mind when I think of bad debt. Those traits are high annual percentage rate (APR), debt used for consumer goods, debt used for something you can’t afford, and debt that isn’t used to invest in something. With that being said, there are a few common types of debt in which these traits are prevalent.

Credit cards

The first type of bad debt is credit cards. Credit cards have historically had a high APR which can kill any efforts you try to make to save money. According to bankrate, the average APR for fixed rate credit cards is 13.02%, while the average rate for variable rate credit cards is 15.61%. These rates are ridiculous! To put that in perspective, the average rate on a mortgage is 4.43%, a five year Certificate of Deposit is 0.79%, and an auto loan is 4.22%. Using the rule of 72, it would take about 4.8 years for your debt to double at a variable rate of 15.61%! These insane APRs are the driver of the figurative quicksand which can sink you in no time.

Credit cards are generally only good for one thing and one thing only: building credit. You can easily build credit by using credit cards on all of you normal purchases and then paying off the balance either immediately or at the end of the month. This way you will not allow yourself to forget about the card payment and only make minimum balance payments. Do not use credit cards if you are not disciplined enough to use them. You will be better off avoiding credit cards if you have a habit of putting off your expenses every month because you think you will have enough money to cover the payment at the end of the month, only to discover you can barely make the minimum payments.

Also, don’t be tempted by the amazing rewards credit cards offer. If you do not have the discipline or the financial means to be able to pay them off every month, all of the interest payments you make to ruin any potential benefits you could hope to get from a rewards card. The only time you should concern yourself with the rewards of a credit card are when you are using a credit card for the sole purpose of building credit, make only typical purchases with the credit card such as food and gas, and pay off the balance immediately or have automatic payments on your account activated which will pay off your credit card balance every month.

Store Credit Cards

Store credit cards are even worse than credit cards. Not only do they have a higher APR, you dare extremely limited in where you can use the credit card. I learned this during my sophomore year in college. I needed to purchase a suit for my first career fair so I made a trip to JC Penney to get one. I found a nice gray suit, and I also had to buy a dress shirt, a tie, dress socks, and dress shoes. The salesman even gave me a great deal, all I had to do was sign up for a JCP credit card, and I would get and amazing discount of $20 off my shoes. Being young a naïve, I took the deal. I was saving $20 so it was totally worth it. I went home, made sure the pay off the balance on my account, and haven’t looked back.

It actually wasn’t until recently that I actually looked at the fine print of the JCP credit card and saw that it had a APR of 27%!!! That’s almost double the APR of the average credit card. Using the rule of 72, it would take only 2.7 years for the balance to double from interest alone! Not only that, but you can only use the credit card at JCPenney, Sephona, CVS, and Rite Aid. All of these places mostly sell consumer goods, which you don’t want to be buying on credit anyways.

There is one last issue with store credit cards. This one could be affecting you, so be on the lookout. There are credit card scammers out there who target dormant credit cards. While you may believe the credit card in your wallet isn’t something you could worry about, scammers can actually get access to these cards and use them for months, maybe even years before you even notice. It is recommended that you check all of your credit card balances every month to make sure this doesn’t happen to you. Do you really want to be checking every store credit card you have every month to make sure there isn’t any suspicious activity, just to save $20?

Moral of the story is never get a store credit card. Saving $20 or $30 just isn’t worth the trouble. The APR is high, the credit is used to purchase consumer goods, and your unused store credit cards are highly susceptible to scammers.

Car Loans

Imagine buying a new car, and the salesman says you can get a great rate of 4.22% on a new car over 60 months. Not too shabby you think, especially when you compare it to credit card debt of 15% and up. Except your car will lose value the moment you drive it off the lot. According to Edmunds.com, a new car will lose 10% of its value the second you put a single mile on it.

What does this mean in terms of your auto loan rate? Let me illustrate this with a quick example. Assume you purchase a brand new car for $30,000 which will be paid over a 60 month period at a rate of 4.22%, the average rate for auto loans. For simplicity sake, let’s assume there is no down payment on the car. When you drive that car off the lot, it will lost 10% of its value, which now makes the car worth $27,000. Now your relative interest rate is 8.62%, given this new, lower value of the car. You are taking out a $30,000 loan on something that is now worth $27,000! Not only that, but after a year of driving, the car will lose another 9% and continue on losing value as time goes on. As I discussed previously, using loans to buy depreciating products is a terrible idea, and a new car of one of the fastest depreciating products you can possibly buy!

I want to end this on one final note: in 2013, Ford made $7.5 billion in revenues from financing cars alone. Do you really want to be a part of that crowd?

Overview

There you have it! To recap bad debt has any of the following traits:

  • High APR
  • Used for consumer goods
  • Used to purchase something you can afford to pay for, even on a monthly basis
  • Not used for investing – instead it is used for depreciating assets

Are there any other types of bad debt you can think of that I didn’t mention above? 

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