Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

The Dirtiest Word I Know in Finance

There are a lot of dirty words in the financial dictionary -- bankruptcy, Black Friday, derivatives, credit default swaps -- to name just a few. But there's one that beats them all hands down.

It can ruin a company, a marriage, a friendship and can undermine the best-laid plans. It is a shackle that can keep you from achieving your personal goals. It can enslave you, and if you abuse it, it can destroy your entire financial future.

To give you a hint, the average American household had $54,000 worth of it in 2009. 

The typical college student will graduate this year saddled with $24,000 worth.  

And American taxpayers carry over $14 trillion of it thanks to the federal government's spending habits.

I'm referring, or course, to debt -- and it's one main causes of financial hardship plaguing the country today.

Most people think of debt as simply part of their monthly loan payment. But the best way to illustrate debt is to look at the total amount of money you spend over the lifetime of a loan. Once you look at debt like that, you can see how expensive borrowing money really is.

For example, say you borrow $100,000 with a 30-year mortgage at 7%. Over 30 years, you'll end up paying $140,000 in interest to the bank. By the end of the loan, you've paid more than double (2.4 times) that of your house's original purchase price.

[See how much interest you'll pay over the life of your own mortgage using our Mortgage Calculator.]

To illustrate just how dangerous debt can be on your personal finances, consider these facts:

  • 1.55 million bankruptcies were filed in 2010 alone -- Many were filed from those who overspent or overextended their lines of credit. Bankruptcy not only remains a stain on your credit report for up to ten years, it can greatly hinder your ability to own a home and sometimes even keep you from getting a job. 
     
  • The average American household carries a credit card debt balance of $15,799 with a typical interest rate of 14.67%. That means even if the household pays a minimum monthly payment of $200, a whopping 97% of that amount will go towards paying interest. At that rate, it would take 24 years to pay off the balance even if the household stopped charging another cent on the card!
     
  • A report last done by public policy institution Demos found that the average credit card-indebted family uses 21 percent of its income just to pay its monthly debt.

It's not a wonder why 74% of respondents polled in a recent Employee Benefit Research Institute survey said they expect to continue working during retirement. 

The rising costs of living and debt have placed a straight jacket on the average American looking to financially prosper. But there are some Americans that have figured out how to avoid the problem.

[InvestingAnswers Feature: 7 Terrifying Things They Don't Tell You About Bankruptcy]

The biggest difference between rich and poor is how they respect their credit.

Rich people know that credit is a tool to be used to their advantage. They know how to cultivate it and how to use it in a way that increases their bottom line. But at the same time, they recognize it can be a double-edged sword that can keep someone from achieving financial freedom if abused.

#-ad_banner_2-#Those who treat their credit with little respect, accepting every offer that comes their way and racking up the balances with abandon, are always the ones who find it difficult to ever get ahead in life.

To them, credit is a limited resource that should be squandered while it's available, with little outlook on what disadvantages they could face in the long-term.

In short, this abuse of credit and debt is the best recipe I know of to remain in a financial prison. 

So what's the single best way to get out of debt today?

Avoid it like the plague.

If you've come out on the losing end of a battle with debt in the past, you need to get back on the horse and pay it off. There's no easy answer here except the slow and steady route of making a repayment plan and sticking to it.

There are plenty of tactics for making headway on this front, and I recommend this article for those in a credit card quandary: 10 Ways to Dig Yourself Out of Credit Card Debt.

And for those that are just embarking on your financial journey, there are three golden rules for dealing with debt and credit. Repeat them like a mantra.

1. Respect your credit score. It's the single best resource you have for securing loans at an affordable rate. Know it, cultivate it and practice good habits for maintaining or improving it.

For more, read our feature: 7 Steps to Perfect Credit.

2. Keep your expenses low. If your basic living expenses take up more than 50% of your income, it's going to be tough to not rely on credit to make ends meet. A good general rule of thumb is that housing should never exceed 33% of your monthly income. A car payment should be no more than 10% of the amount you take home. Practice good spending habits and you'll be less likely to turn to credit when in a financial pinch. 

3. Choose your debt wisely. Some debt is good debt. Mortgages and student loans with low interest rates are often times necessary to leverage yourself into a prosperous future of higher earnings or financial stability. But consumer loans with exorbitant interest are an impatient man's folly. But whether its good debt or bad, if the payments are more than you can afford, you're simply spreading yourself too thin and setting yourself up for failure.

The Investing Answer: Like most bad habits, debt is easy to pick up and a real nightmare to put down. For those with a solid respect for their credit score and their account balances though, debt is a problem they will rarely have to face. Know what you're getting into before you sign up for any loan, and always keep a rational head in regard to the realities of what it will actually take to pay down a balance.