What is Financial Freedom?

As you know this blog has been inspired by financial freedom. While there are differing opinions about what financial freedom, this article will present financial freedom from my personal perspective.

What is financial freedom to me?

Financial freedom to me is having enough money to live without ever really having to work again. Now this does not mean you never have to work again. Instead it means that you work on your own terms.

You never have to worry about the stress of losing your job. You don’t have to worry about whether you have clients or not. When you are financially free, work no longer becomes a requirement in life but rather a choice.

How would you get there?

There are a number of ways to achieve financial freedom. The most effective way is by building passive income streams. This is done in a few ways shown below.

Have Your Money Make You Money

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Build up enough cash so that it will generate money-almost like planting your very own money tree.

The first way to build a passive income stream is to build up enough cash so that it will generate money. Use your cash to purchase dividend paying stocks or bonds which pay you interest. You could also purchase annuities which would pay you over the life time of the annuity.

For example, if you have $5 million in cash right now you could invest in bonds which pay out 5% a year. Just by having those bonds alone, you will generate $250,000 a year in interest income!

Imagine, $250,000 in your pocket and you don’t have to do anything at all! You can accomplish this with dividend paying stocks as well.

Stocks pay a wide range of dividends, and are not quite as reliable as bonds for paying you out every month.

But stocks do have the advantage of appreciating in value over time, so that when you sell the stock you have a chance to make more money.

I don’t have $5 million to put away, what should I do?

Fair enough. Most of us do not have $5 million in liquid cash at our disposal at any time. So what should you do instead?

Create a Business which Produces Cash with Minimal Effort

While I was writing that subheading, it sounded a tad bit scammy. Just like one of those spam emails which tell you how some guy makes $5,000 a day just by clicking a few buttons.

There are people out there with legitimate businesses that do not require much effort on their part.

They do this by doing one of two things

1)      They automate their business so they don’t have to do most of the work or,

2)      The create a product which they can sell to the masses

In order to accomplish number one listed above you would do a few things. First you would have to build a business up from scratch (if you can’t buy one initially).

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Automating your business by hiring employees is one method you can use to become financially free.

Then you would look to hire employees to help do the menial tasks that you don’t want to do. Then finally you would hire a manager to help oversee the employees and take care of the higher level duties that you don’t want to do.

This leaves you to plan for the future and grow, and takes you away from the day-to-day tasks that you would be doing at any typical 9 t
o 5 job.

For the second item, you would create a product that you only need to create once or can be created by others, and sell it to the masses.

Key Point: Learn How to Separate Time From Money

The key to building a passive income business is separating your time from money. Most jobs will pay you for every hour you work.

It has been engrained in us that we get paid when we work and don’t get paid when we don’t.

What if you did get paid when you didn’t work? How would you like to get paid when you didn’t work? When you are sleeping? When you are on vacation?

If you have an automated business, you will no longer trade your valuable time for money.

There are a ton of ideas to help you build up passive income streams. One of the best books to help you understand the different types of business systems is “The Millionaire Fastlane” by MJ Demarco.

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Check out The Millionaire Fastlane, one of my favorite business books that I’ve read recently

In that book he lays out the “Five Fastlane Business Seedlings” which are business systems which produce passive income for the owner. Those five systems are

  1. Rental Systems
  2. Computer Systems
  3. Content Systems
  4. Distribution Systems and,
  5. Human-resource Systems

If you want to find out more, check out the book on Amazon. It really is a great resource and I would recommend it to any entrepreneur or wantreprenuer looking to get started.

My Top Three Reasons for Wanting to Achieve Financial Freedom

I have told you what financially freedom is to me. Know I want to elaborate on why it is my goal to achieve financial freedom.

Reason #1: I want to have the freedom to do what I want when I want

If I want to sleep in until 12 I can.

If I want to meet friends for lunch on the other side of town at the last second I can.

If I want to go on vacation at the drop of a hat I can.

I would also have freedom to pursue hobbies that you enjoy but would never really make you money.

For example, I enjoy playing basketball and golf. I am not really good at either one of those. I could play those whenever I want.

Reason #2: I want to explore the world

Many folks don’t have to be financially free to explore the world, but I think it would be pretty amazing being able to travel all over without a timeline to get home like you would when you work.

I have never traveled much, and I think it would be great to be able to see the world.

Being financially free would allow me to travel on my own time, and have the money to do so.

Reason #3: Spend more time with those I love

I am personally not a workaholic. I’ll admit it.

I will work really hard doing the job the needs to be done. Once it is complete I go home and do the things that I want to do.

It’s not even that I am lazy, but I just like to enjoy life and do those things that I want to do.

I don’t want to feel obligated to go into some place five days a week for the next 35 years of my life.

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You now know my reasons for wanting to achieve financial freedom. What are yours?

I enjoy spending time with family and friends, and financial freedom will allow me to do this.

Down the road when I have kids, I want have the ability to spend time with them. I want to be a part of their life.

I don’t want to be at work all of the time and come home and be too tired to spend time with my family.

This is what financial freedom is to me. This is why I want to achieve it. What is financial freedom to you? Why do you want to achieve financial freedom?

Photo Credits (in order)

Flickr/Shari’s Berries, Flickr/Phil Whitehouse, Flickr/Kalyan Chakravarthy

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Free for Five Days: “Get Rid of Debt Forever: A Guide to Understanding and Conquering Debt”

I am making this post to inform you that my first eBook, “Get Rid of Debt Forever: A Guide to Understanding and Conquering Debt” is available for download on Amazon for free for the next five days.

From August 21, 2014 to August 25, 2014, you can have the book sent straight to your Kindle or any other device and it will be completely free. All you have to do is go Get Rid of Debt Forever: A Guide to Understanding and Conquering Debt and click download to have it sent to you today.

This book (along with other projects) has taken up quite a bit of my time. As a result, I have not been blogging as frequently as I would like, and I apologize for that.

But, I have learned a lot in this process and I want to use this blog post to discuss what you will find in my book, why I decided to create this book, and what I learned in the process.

What You Will Find

The eBook I created is a collection of blog posts that I have made on this site, along with a few added chapters not found here, organized and put into one place.

You see, I originally intended on creating a comprehensive guide on personal finance that would be found on this blog. I came up with this idea back in April and it seemed like a great idea at the time, but then I recognized something.

My realization

I realized that I was writing A LOT. And I was only writing on one individual topic which was debt. If I was going to create a comprehensive guide on personal finance, it would take a LONG time.

What I decided to do was repackage these blog posts on debt into an eBook. I was originally planning on giving this eBook away as an incentive for people to subscribe to the blog. Then I changed my mind and decided I wanted to publish it on Amazon, which I’ll get to in a minute.

So I decided to repackage the book, add some chapters and make it more organized, and edit it to make it a little less informal and free from error (at least that’s what I hope!).

Why Did I do This?

I mentioned above that I was going to give this book away as an email opt-in book. There are a couple big reasons why I wanted to publish my eBook on Amazon instead.

Reason #1: I wanted to create my own product

The first reason is quite simple. I wanted to create my own product that I could sell. I wanted a product that has my name on it that I could put out there for people to purchase.

At the end of the day, that is why we are here. I thought it would be great to repackage these posts, make them more organized and better written, and allow people to purchase my product.

What I hope is that people get some great value out of this eBook and that it will help them.

Also, I want to work on some advertising and marketing skills. By creating my OWN product to sell, I can create advertisements to sell something that can give me some sort of a return on investment.

In the process, I will sharpen my advertising skills which will help me dramatically in the future.

Reason #2: I wanted to learn the Kindle Direct Publishing platform

I plan on writing a lot more in the future. This will include many eBooks which I want to sell to help solve people’s problems.

For this reason, I want to learn the process of creating a book and putting it on the Kindle platform. I have learned A LOT in the process. Discover what I learned in the next section of this post.

For this reason, I figured I might as well learn this platform and process now so that I won’t have to face this learning curve in the future.

What Did I Learn From Writing this Book?

Writing is hard. Despite the fact that this is a short eBook, it was still a long process. Creating, editing, and now advertising has proven to be a challenging process.

When writing a book it would seem that writing should take up the most time. Not for me. The thing that took me the longest was the editing and formatting of this book.

It took a while to make sure everything sounded good and the format of the book was good for the Kindle platform. I went through a few rounds of editing with my girlfriend which took a little longer than I was hoping.

Also, creating the cover is another challenging process. Luckily for me, my girlfriend grew up doing graphic design and was able to help create a pretty good looking cover photo for my book.

Creating is fun. I love creating something and putting it out there for all to read. For me, writing is such a rewarding experience. So much that I plan on creating and releasing another book soon.

Staying balanced is hard. I have had to balance writing and editing with my full-time job, along with social media for this blog, blogging, and having a life.

As a result, my blog has suffered. I haven’t written a post in about a month here. It is difficult balancing all of these things but a lot of people do it and I’m not going to complain.

The Most Important Lesson of All

Even if I fail it is okay.

I would be perfectly fine if my book sales don’t take off. Obviously I’d be happier if I made a million sales of course, but if sales fall flat I won’t have any regrets.

What I have learned through this entire process is more valuable than anything. Even if I fail, no one can take away those skills I acquired and the knowledge that I obtained. These skills can transfer over to other areas in my life down the road.

On top of that, I have something to show for my time. Instead of wasting time on TV or fooling around, I have an actual product that I can point to and shows what I did.

Finally, if I didn’t try, I never would have learned anything new at all.

Takeaway

Writing a book is fun. I recommend anyone try it out. It’s not easy by any means and it takes time and it probably won’t be worth it money-wise. But the experience you gain will be completely worth it.

Once again, you can get my eBook “Get Rid of Debt Forever: A Guide to Understanding and Conquering Your Debt” completely free on Amazon for the next five days. Click the picture below to check it out!

I would love to hear your feedback, so if you could leave a review on Amazon I would greatly appreciate it!

Get Rid of Debt Cover

From August 21 to August 25 you can get your copy of my eBook completely free!

Should you pay off your mortgage or invest your money?

Suppose you win the lottery and you win just enough to pay off your mortgage. Should you pay off your mortgage? Or would you be better off investing that money?

In order to answer this question, we must weigh a number of factors. The most important factor deals with your risk profile. You will also want to consider how your current investments are allocated. There are numerous other factors that you must consider. Before we get to all of those factors, let’s make a few assumptions.

Let’s assume the following:

Yeah, I know the saying about people who assume. However, for purposes of answering this question in as full of detail as possible, I need to assume a few things before we dive in and discover my opinion to this question.

The following assumptions are being made:

  1. You have 25 years left on your mortgage so you have a long timeline left to pay it off.
  2. You are in the 25% federal tax bracket, and will remain there for the foreseeable future.
  3. In addition, your state income tax rate is 8%
  4. You current mortgage rate is on par with national averages at 4.5%
  5. You have $200,000 left on your mortgage
  6. You expect the average rate of return of the stock market to be 8% over the next 25 years.

With those assumptions being made, we have the foundation to truly evaluate what you should do with your lottery winnings: invest in the stock market or pay off your mortgage?

Tax deductions make your interest rate lower

The first item that you must consider is that your interest rate is really not the 4.5%. Why is this true? The United States has favorable tax deductions available to homeowners, so your actual interest rate will effectively be lower. What would be the effective interest rate based on our assumptions above?

Your effective interest rate after considering the mortgage tax deduction would actually be 3.105%. How did we arrive at that number? Using this handy calculator at Bankrate, you can easily calculate what your interest rate will be after your mortgage tax deduction.

Go ahead and play with the calculator a bit. It is interesting to see how much the mortgage tax deduction will actually help you. In this example it is almost like cutting 1.4% off your interest rate on your loan!

Paying off your mortgage means no mortgage tax deduction

Why is your interest rate important? This will help us in making our final decision whether to invest our money or pay off the mortgage.

If you choose to pay off your mortgage, you will no longer be eligible for the mortgage tax deduction. You will have to pay more in taxes as a result. But, you won’t be making mortgage payments anymore!

So it looks like a win for paying off you mortgage, doesn’t it? But wait, it can’t be that simple. Well…I guess we have to consider a few other factors before making our big decision.

The opportunity cost of paying off your mortgage

Paying off your mortgage would be a great relief. However, there is an opportunity cost to paying off your mortgage. Ah, opportunity cost, that word you used in economics and never thought you would see again.

By paying off your mortgage, you are foregoing other options with your lottery winnings. What specific opportunity costs can you think of by paying off your mortgage?

The biggest opportunity cost to me is that you will not have that money to invest. This is the biggest opportunity cost in my opinion, so hear me out.

By paying off your mortgage you are taking all of your money off the table to get rid of a huge debt, which can be a relief. However, you will not be able to do anything with that money once to pay off your mortgage.

This brings up an age old question: Should you invest or pay off your debt?

Generally, you would rather invest any extra money when you can achieve returns which are higher than the interest rate on your debts. For example, let’s say you have a loan with 2% interest. Let’s also say that you can make an investment which will return 5% in the next year.

If you choose to pay off your loan, the money will be gone for good. However, if you choose to go with the investment, your money will appreciate by 5%. Now you will have to pay 2% on your loan. As a result, you end up with a net positive return of 3%. Simple enough, right?

The answer is staring you right in the face

Let’s go back to our original example and decide whether you should pay off your mortgage or invest in the stock market.

Based on the assumptions being made, you will be able to achieve an average annual return of 8% in the stock market in the next 25 years. During that same time period, you will be paying an effective interest rate on your loan of 3.105%. You do the math. What will be your total net return of this decision?

Got your answer? Okay good.

I’m sure you answered 4.895% you smart cookie. For simplicity sake, let’s just say you will get an average net return of 4.9% if you decide to invest in the stock market and keep your mortgage as is.

This is precisely where I would stop and not even consider paying off the mortgage. I’m a numbers guy, and the numbers are telling me one thing: INVEST! However, I know that many people aren’t as into the numbers as I am, so I will lay out a few other factors that will help you make your decision.

Factor one: Your risk profile

Your decision will depend heavily on your risk profile. If you like to take on risks and live life on the edge, you would want to invest in the stock market regardless. You don’t care about the fluctuations of the markets, you live for this sort of thing!

Even if you have a moderate risk profile, you would likely opt to invest in the stock market as opposed to paying off your mortgage. Sure, paying off your mortgage would feel good, but you know there is a very good probability the market will return around 8% in 25 years’ time.

If you are extremely risk averse, you will take the sure thing and pay off your mortgage. What if the stock market crashes tomorrow and you lose all your money? You don’t want to take that risk no matter how unlikely it is. You want a sure thing, and the only sure thing is today. You would get rid of that mortgage.

Based on your risk portfolio, what would you do in this situation? Would having a shorter time horizon make you more likely to pay off your mortgage?

Factor two: Asset allocation

Another factor you have to consider is your asset allocation. This will depend on how many assets your had just before winning the lottery.

If you have very few investments, and you choose to pay off your mortgage, you are essentially putting all of your eggs in one back: real estate. This will throw your asset allocation all out of whack, and you will have a high risk exposure to the real estate market. This risk is even higher when you consider you are putting all of your money into one single asset: your home.

If you have few investments and choose to invest in the stock market, you are better able to spread your risk out among number companies, funds, and indexes.

However, if you already have many investments you would not be as impacted by choosing either option. We would assume that you already have a well-balanced profile. Paying off your mortgage wouldn’t expose you to asset allocation risk.

Factor three: Interest rates

In the example above, I illustrated that if you had a low interest rate you would be better off investing in the stock market. I did not consider the factor of higher interest rates.

The interest rate on your mortgage will affect whether or not you choose to invest your money or pay off your mortgage. Logic says the higher the interest rate on your mortgage, the better off you are to pay off the mortgage.

Other factors to consider

Psychological effect of paying off your mortgage early

Paying off your mortgage is a huge accomplishment. For many people, paying off debt is a rewarding experience. You will sleep better at night knowing that your will not have to make to monthly payments every month.

You will no longer have to worry about whether you will have enough money to make mortgage payments. The only payments you will have to make will be for insurance, property taxes, and any miscellaneous repairs and other expenses.

You will have excess cash to invest

While you won’t have the initial $200,000 to invest when you first pay off your mortgage, you will have an extra $1,000 to invest.

While you are deferring compounding interest on your investments, you will also be reducing your risk over time. Having this extra money each month will give you some flexibility for investing and give you extra cash flow every month.

Question to consider:

Would you borrow 3.1% to invest in the stock market?

Answer: for me the answer is a definitive yes. That is basically the decision you are making if you do decide to take your lottery winnings and invest them in the market (again, using our assumptions about market return made above).

What do you think you would do in this situation? Do you think you would pay off the mortgage or invest your money? What other things must you consider before making this decision?

What is anchoring and how can it make you spend money?

Anchoring is a psychological heuristic that influences your ability to assess probability and make decisions. Anchoring is the common human tendency to rely on the first piece of information which is available to them, known as the anchor.

In more general terms, anchoring is the idea that we start with some information, a specific number for instance, and then work our way from there to make a decision.anchoring makes you spend money

Case study

Drazen Prelec and Dan Ariely conducted an experiment at MIT in 2006 where they had students bid on various items, such as a bottle of wine, a cordless trackball, and a textbook.

They had student write down the last two digits of their social security number, and had them pretend that this was the original price of the item. They then held an “auction” where they asked each student how much they would pay for each item.

For example, if the last two digits of their social security were “82”, the student would write down 82 on the top of their page, and then write $82 next to every item listed on the sheet of paper in front of them. Once this was done, the professors would describe each product, and the students would write down how much they bid on each item.

Remarkably, the students with the highest social security numbers (from 80-99) bid the highest amounts and those with the lowest (1-20) bid the least amount. As a matter of fact, those who had a social security number in the upper 20 percent bid 216 to 346 percent higher than those in the lowest 20 percent!

The crazy thing about this study is that the student did not believe writing down their social security number next to each individual item would affect their bidding. However, that number next to each item subconsciously made the students spend more (or less) than their peers depending on how high or low their social security number was.

What does this study prove?

We are affected by the first number that we see when it comes to making a decision. Although you can deny it all you want, anchoring is a common way that people make decisions, especially when it comes to making a purchase. The study above, along with many others, have shown that people use the initial number as a starting point and then work their way up or down from there.

Businesses use anchoring to make you buy more

How often have you bought a product because it was 50 percent off? Or how often have you bought something from the grocery store just because it was buy one get one free, even though you didn’t really need it? Did you ever stop to wonder why you bought that product?

Anchoring is the reason we buy products that are on sale and listed so cheaply. We have an initial number in our head, and we work our way from there to make decisions. If you don’t have a number already in your head, manufactures will certainly remind you what retail price is.

How can you avoid anchoring?

Unfortunately, studies have shown that it is almost impossible for us to avoid anchoring. They show that the moment we are presented with an anchor, our minds are contaminated and have a tendency to always go back to that number.

Take gas prices for example. Personally, my anchor for gas prices is around $2.30, which is the price gas was when I first started driving a car. It was the first number that I was familiar with when I had to first pay gas, and every time the price of gas goes up I think back to the days when it was only $2.30 a gallon.

If I can’t avoid anchoring, what can I do?

Anchoring is hard to avoid. The fact is, we do it on a daily basis. One way you can avoid anchoring through your purchases is the ask yourself: do I need this? Sure, it’s great to see something that is 50% off, but does that change the fact whether or not you really need that item? Probably not.

Ultimately, the best thing you can do is be more aware of anchoring and seeing how it effects you in your everyday life as a consumer. By understanding that you make irrational decisions due to anchoring, you will be more likely to make wiser decisions in the future.

What purchases have you made due to the anchoring effect? 

Changing Plans and Shifting Gears

I want to make a quick blog post updating my progress on my guide to personal finance. I have decided that I will split up the original guide into multiple parts which will relate on various personal finance topics, starting with debt. In the next month or so I will be revealing the “Comprehensive Guide to Controlling and Conquering Your Debt” which will be completely free to anyone who visits my blog.

The guide will cover many topics of debt which I have posted on my blog over the past month or so, along with a few new topics which I have not yet discussed. This guide will also be available as an eBook in pdf format if you subscribe to my blog. All you need to sign up is your email address to get started!

Why am I doing this?

There are thousands of personal finance blogs online which are all great resources of information. The goal of creating these guides is to provide one comprehensive place for you to access this information in an organized manner. Each guide will be like a mini book which will provide a wealth of information and actionable tips for you to get started on your journey to financial freedom.

How do I get started?

Just fill out your email information below and hit subscribe. Once the guide comes out you will be the first to know and I will send you the eBook straight to your inbox without any effort on your part.

Businesses know how to make you buy a product. Don’t become a victim of their mind tricks.

What an amazing deal! I can’t believe I’m getting such a steal! 

When buying a product on credit, it’s not hard to fall victim to believing you got a great deal. Big companies know how consumers think and they know how to get a product into their hands as quickly as possible. Millions of dollars are spent advertising and researching consumer behavior.

One technique companies use to peddle their product onto consumers is to make them believe they are getting an amazing deal. I’m sure you’ve seen infomercials which tout that you can buy a product with “6 easy payments of $99 a month, no money down!” Would you still but the product if they told you it was “$600 dollars plus interest at a ridiculously high interest rate!” I don’t think so.

This same thing goes for cars. In the last article I discussed the negatives of taking out car loans. Once again, companies with throw out phrases like “only $299 a month for 60 months.” For them, it’s all about framing and making your gigantic purchase seem not so gigantic. When you spend a little amount over a long period of time you are dying a very slow but painful financial death of a thousand cuts. You become a servant to the lender and lose any chance at financial freedom.

The little things add up on both sides of the coin

You know how saving small amounts over time can add up? Well spending small amounts over time can have that same effect, except you suffer instead of benefiting. Don’t get fooled into thinking you aren’t paying a lot. Don’t look at purchases as payments in monthly installments. Take a step back and realize what the total cost of your purchase is, and then decide if it is really worth it to you.

We are all victims of the instant gratification bug

Instant gratification. We are all guilty of it. How could we not be. We live in the of the fastest generations ever. I was on Amazon the other day looking for books to read and stumbled across one that was on my short list of books to read. I went to the page for the book and in less than 10 seconds and the click of a single button, that book was delivered to my Kindle. I even commented to my friend how scary it was that I just bought something with the single click of a button.

With how quickly it is to buy things now, it is easy to get tripped up and knocked off the path to financial independence. In a matter of seconds you can spend hundreds, heck, even thousands of dollars. Back in the olden times you actually had to get in your car, drive to a store, find the item you wanted before you could even purchase it. You had time to think about the purchase you were about to make before you made it. By the time you got to the store you may have even reconsidered making the purchase altogether.

Once again, companies are behind making it easier for consumers to buy products. The faster you can buy a product, the less time you have to think about whether or not you truly needed it. It is their job to figure out how to get a product into your hands as fast as possible. Look around you. It’s everywhere. Fast food, Wal-Mart on every corner, one click purchases.

Considerations you should make before a major purchase

1)      Do I really need this product?I advise you, before you buy a product, take exactly three minutes before you click buy and consider the following:

2)      Will I still be satisfied with this product in six months?

3)      Does this product help improve my life?

4)      Is this not an impulse purchase?

5)      Can I afford this product without going into debt?

6)      Finally, Do I have a good reason for this purchase?

psychology of debt

The more “Yes” answers you have, the more likely it is that your purchase is a good one. It can be a dangerous trap when you combine instant gratification with credit cards. Not only are you mindlessly buying something, you are buying it with debt which can take months or years to pay off. This is precisely why I advise you take at least three minutes to really think about what you are about to do. Don’t set yourself back two years for a purchase you made in ten seconds.

Summary

  • Companies know how consumers think, and will make a large purchase appear smaller by giving you the cost per month instead of the total cost of a product.
  • Just like saving a little bit adds up over time, spending a little bit in monthly installments will add up over time. Understand the actual cost of your purchase.
  • Companies know consumers seek instant gratification and have responded by making products quicker and easier to buy.
  • Take into consideration the six questions I listed above before you make a major purchase. Don’t let a split second decision set you back years.

Photo Credit/Flickr User Paul Inkles

The Psychology of Debt: Part One

psychology of debt

Close your eyes and think about a time when you entered into debt. What was your thought process as you made the decision to take out that loan? While it is simple to say that you just needed to borrow the money, it is important to look deeper at your mindset when you entered into debt. How you think about money and debt can have a huge impact on your financial decisions down the road. By understand the mind and psychology behind debt, you can greatly improve your future decisions regarding debt management. When you are finished with this series of articles you will have gained insight on why people enter into debt, how you’re impressions of money impacts debt decisions, the need for instant gratification, and the psychological concept known as “conspicuous consumption.”

Why do we get into debt?

Debt opens up opportunities to make purchases you couldn’t have made otherwise. It’s only recently that credit cards and other forms of credit have risen to popularity. As you know, having debt is a doubled edged sword which can be amazing if utilized right, but absolutely horrific if used incorrectly.

You subconsciously believe you have more than you do

Credit cards give you the impression of having more money than you really do. If you have access to a card with a $1,000 limit it appears that you have $1,000 that you are allowed to spend. Mentally, you believe that I you actually have the money in your hands and freedom to purchase whatever you may like. You don’t really have to consider whether or not you can afford the purchase. Instead, your mindset shifts into thinking “I still have money left on my card, so I can make this purchase. I may not have the money right now but I can make payments and figure out all of that stuff later.” Don’t be a person who needs to “figure it out later.” If you need to figure out how you are going to afford something, you can’t afford it. Put your card back into your wallet and walk out of the store.

You begin to justify your purchase when you believe you have money to spend just because you have maxed out your card. One way of justifying a purchase was already mentioned, “figuring it out.” Other ways people justify purchases is by telling themselves that it is “just this one time. It won’t happen again.” The issue with this is that once you do it one time is so much easier to do it again. Look at drug addicts. How many started out by saying they were just going to take one hit? It can be a slippery slope if you fall into the “just this one time” trap.

Another justification is that you will make more money and that you can afford minimum payments until then. Maybe you are expecting a raise or maybe waiting on a big check from one of your clients. Whatever the case may be, you justify your large purchase because you will be “making more money soon.” Avoid this pitfall as well and remember, don’t spend money that you haven’t yet earned. You are putting the cart before the horse if you do otherwise.

Have you ever justified one of your credit card purchases only to regret it later? What was your justification?

Photo Credit/Flickr user digitalbob8

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? 

Credit cards are great!

Credit cards don’t put people in debt, people put people in debt. Credit cards have a negative stigma around them due to their high interest rates and the horror stories from individuals in huge debt. As a result, many people are afraid to take out credit cards. In this article I want to dispel those myths and explain some of the great benefits you of owning a credit card.

What are the benefits of having a credit card?

Benefit #1: Credit Cards will help you build credit.

Good credit isn’t something we think of until we need it. It’s not as if we go through life thinking about what our credit score is. For that reason we tend to ignore this first benefit of credit cards. Having a good credit score can save you tens of thousands of dollars in the future.

How does you credit score affect interest rates?

The better your credit score, the lower an interest rate you pay on loans. For example, let’s say you borrow $200,000 to purchase a home on a 30-year fixed loan. According to myfico.com, if you have a credit score of 650 (which is considered a “fair” score), you will pay and annual percentage rate (APR) of 5.085%. However, if you have a score of 700 (which is considered a “good” score) you will pay an APR of 4.624%. What difference does this make over a 30 year period? If you have a “fair” score, you will pay $190,260 in interest over the life of the loan. If you have a “good” score, you $154,787 in interest over the life of the loan. This is a savings of $35,473! Try it out yourself! Go to http://www.myfico.com/myfico/creditcentral/loanrates.aspx and play around with some numbers and see what you discover.

Benefit #2: Credit card companies have strength, and will help you when you need it.

Another great benefit is that credit card companies are on your side when you make purchases. If you buy a product that you are not satisfied with, and the company you bought the product from is giving you a hard time, the credit card company can help save you the headache of trying to get your money back. If a company won’t refund your money, chances are the credit card company will. This is called a chargeback. The threat of chargeback will give the company you purchased from an incentive to provide good customer service and timely refunds if appropriate.

Benefit #3: Extended Warranties

Many credit cards will extend your warranty up to a year for purchases you make with your credit card. This can come in handy, especially for large electronic purchases. There is no need to buy the extended warranty if you make you purchase with a credit card!

Benefit #4: Customer Rewards

Many cards will pay you nice rewards in the form of travel miles or cash back bonuses. For example, American Express offers 6% cash back on groceries and 3% back on gas if you get their Blue Cash Preferred Card, which costs $75 a year. Chase offers 5% cash back on a rotating list of categories and 1% cash back on all other purchases with their Chase Freedom Card. There are a number of other cards which offer great rewards and travel miles, which I won’t go into too much detail here.

Credit cards have a number of benefits to consumers as stated above. If you are a reliable and responsible with your debt, a credit card could be one of the best investments you make.

What do you think of the benefits to owning a credit card? Do you own any credit cards? Why or why not?