Wealth Building 101 - Debt (Part 1)

I’d like to drop anchor here and spend some time talking about what I consider to be the number one killer of personal wealth today -- debt. It’s so important in fact, that I had to break this into multiple segments. Just to be clear, I’m not one of those who believes debt should never be used, it’s used all the time in businesses and it’s impractical to expect someone to live completely debt free all the time, especially when they’re young and just starting out. However, I do believe it should be used very sparingly and wisely.


The key difference in thinking of those who are successful in using debt well and those who aren’t is that the ones who handle debt properly use it as a tool, while the people who allow it to get out of control use it simply as an extension of their income to live beyond their means.


Obviously, one of the key things to consider when dealing with debt is the interest rate you commit to. Let’s say for example that you take out a car loan for $20,000 @ 8% interest. Just using rough numbers to keep this simple you are going to wind up paying somewhere slightly below $1,600 for interest in the first year of the loan. This means that, in addition to the small amount you are applying to the principal (the actual money you borrowed), you are going to be shelling out somewhere in the neighborhood of (staying with round numbers here) $130 a month just for interest alone -- this is after tax money. Now that’s a chunk out of some people’s budget, but it gets worse. Assuming that your tax rate (including FICA, Federal, and State) is somewhere in the neighborhood of 35% (and this is being pretty conservative) that means that your actual pretax income to service the interest on this debt is going to be somewhere around $200 a month. So, if you make $48,000/year you’re basically using around 5% of your gross income just to pay interest on this one loan! How’s that for a pay cut?

Another thing to take into account is whether the interest is tax deductible. Mortgages and home equity loans/lines of credit are generally deductible for most people who itemize on their taxes. Interest on student loans are tax deductible for folks who are under a certain income level whether they itemize or not. There may be a few others that qualify, but these are the most common. You should talk to your tax advisor to see which interest qualifies as tax deductible for you.

Going back to the example used earlier, if that loan were a tax deductible home equity loan you wouldn’t have to factor in some of the taxes (sorry folks, FICA’s not on the table when it comes to tax deductions. After all, we have to feed the monsters we call Social Security and Medicare.) So, you could cut the actual amount of pre-tax income you have to produce to service the interest by somewhere between 25 – 30% just by choosing the source of your loan carefully and shopping for the best interest rate.

One last thing to consider – try very hard to never commit long term to a variable interest rate. Uncertainty is never your friend when dealing with finances and variable interest rates are the epitome of uncertainty. This is one of the things that got a lot of people in trouble during the real estate meltdown!

In the next segment, our discussion will be centered around the (evil?) practice of credit card use. I hope you’ll join me for that!

Assignment: Make a list of all your debt. Analyze each one to see what the interest rate is. Determine which ones are highest taking into account which ones have tax deductible status. Rank them in order from the highest interest rate to the lowest. Hang on to this list – we’ll be using it later when we talk about debt reduction and tweaking our budget.