FinTekNeeks

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Let’s Talk About Debt

Posted in Money

Willful waste makes woeful want.

~ Eliza Rockefeller

Personal finance writers love to write about debt and ways to minimize its impact on you, along with strategies for how you can pay it off or deduct it out of your taxes. If you like the sound of that, I didn’t write this article and I don’t intend to waste time writing financial articles on debt. My view is, “You’re in debt? Pay if off quickly. Move onto other things. The end.” This is my way of writing that you might find other sites more appealing than this one if you plan to borrow and stay in debt for a while. Let’s suppose that you are in debt, but want to eliminate it quickly, or you want to know why you should. Debt is money extracted from your future to pay for your present and in this article we’ll use the example of students loans because you’ll generally see positive news about them as far as interest rates and the fact that many of them can be deducted off taxes.

Freeport McMoRan (FCX) is a great example of a company that foolishly borrowed too much money and saw its price contract.

Let’s Talk Numbers

Let’s imagine that you have the following student loan amount:

$50,000 at 4% APR

Using the initial principal – the amount owed ($50,000) – how much interest will you pay in one year?

50000 x 0.04 = $2000 (since APR – annual percentage rate – is calculated annually, but divided daily, you would owe an estimate of $166.67 per month in interest)

You will lose $2,000 your first year, assuming that the principal of $50,000 remains unchanged throughout the year. This leads to one of the most important lessons about debt that some don’t realize – the amount of interest that you owe is determined by the amount of principal that you borrowed and that is currently owed. Notice the word currently because principal can change as you pay the loan – many loan payments include principal in the payment, meaning that in our example, the $50,000 would decrease. Let’s look at the mathematics of that: suppose that our first payment on the $50,000 was the interest of $166.67 plus $10,000 – which would be subtracted from the principal. Therefore:

$40,000 x 0.04 = $1600 ($133.34 per month in interest)

The amount of interest for the next payment – $133.34 – dropped. The reason it dropped is because we paid extra principal, which reduces the amount of interest that we owe each month. The amount of interest that we pay is determined by the amount of principal that we owe. If we want to pay our debt back faster, we pay extra principal; if we want to pay our debt slower, we either pay only interest on the loan (the principal never drops), or we pay very little principal for each interest payment we make. Student loans also have a rare feature called negative amortization, which means that unpaid interest is added back to principal – you must be very careful about this because it means that principal that you owe increases, therefore the amount of interest that you’ll pay each month will also increase.

Other APRs

So far, we’ve discussed fixed loans with low APRs – 4% APR. In some cases APRs can fluctuate, meaning that the amount we must pay in interest rises or falls and this can be related to the interest rate published in the Wall Street Journal or relative to the risk. For an example, credit cards generally have what’s called a default rate, which is the interest rate that you’ll pay if you default. Generally, it’s higher than the rate that someone might have to pay, if they have stellar credit. Interest rates also reflect risk, especially if the debt is unsecured – meaning that in default, the lender doesn’t have collateral. Collateral-based loans generally have much lower interest rates, as the lender never risks officially losing everything – he can always sieze the collateral if the borrower defaults. The most popular collateral debt is debt tied to a home (mortgage, equity loans and line) or debt tied to a vehicle, such as an auto loan. When working for the bank, unsecured loans compared to collateral loans generally differed in average by 10-11% in APR. Using my own experience in peer-to-peer lending on unsecured loans, a person should never lend money on an unsecured loan at low interest rates because the default rates are enormous and you can quicly lose money if you don’t offset the risk with higher rates. Numerically, high rated peer-to-peer unsecured loans generally have a default rate of at least 11% – that means that an 11% APR only breaks even – unprofitable. The key for you to understand here is that banks don’t charge high interest rates on unsecured loans because they’re greedy, like mainstream media like to state, they charge high interest rates on unsecured loans because of risk – if you improve your risk profile, you’ll generally see lower rates. You have to think like someone who’s worried about lending, and very few borrowers do that.

Student Loan “Forgiveness”

So, let’s critically think here and ask a question related to debt – why would the government forgive student loans after so many years of paying on them responsibly? Is the government being gracious, or do they know something we don’t know? Student loans offer an interesting case here because the government doesn’t forgive other debt, and we know that the government makes money from student loans, so why would they be so eager to forgive debt after a period of time. Consider the following facts:

  1. On Wall Street, one of the greatest concerns is prepayment risk, which is when a borrower pays off a loan early. This means that the lender doesn’t receive as much interest as he would have received if the borrower went the full term.
  2. People generally make more money as they get older than when they’re younger and large student loan balances will affect people who will probably have higher incomes later than those who will stay below median income.
  3. People would behave less economically rational if they limited their income to have their student loans forgiven, unless they had a massive balance. Even in those latter cases, forgiveness after a period of time still locks in a huge amount of interest. In addition, someone who did work little to have their loans forgiven would easily be taxed in other ways, as low income people don’t tend to recognize or offset other taxes, such as inflation, like those with higher incomes do.
  4. Using our scenario above, imagine that someone got aggressive and paid all $50,000 in one year. Note that he’d pay less than $2000 in interest for that year. What about someone who made the minimum interest payments? He would pay at least $2000 for that year and still owe $50,000. Who makes the government more money?

The point here is that loan forgiveness from a pure probability perspective would indicate that the borrower will more than likely pay out a huge amount of interest, be disqualified later because their income is higher, then pay off only after paying quite a bit of interest. To the government, a person taking a second or third job to pay off their loans quickly would mean a loss of revenue. In a sense, this loan forgiveness almost guarantees that many loans will generate them a strong amount of interest. Based on comparing the behavior of people who qualify for forgiveness to people who don’t, this almost always occurs.

How Lenders Weigh You

How do lenders assess you as a borrower? Despite what you may read or hear, no bank approaches lending in an absolute manner, but generally uses patterns to assess risk. In the time that I’ve worked for the financial industry, I’ve seen at least seven or eight different approaches to evaluating risk. I’ve seen the below patterns the most:

  1. Credit utilization: this is how much credit is available to you and how much credit that you’re using. Example: you have a $10,000 credit card, but you never use more than $800 at a time. Generally, banks and lenders will rate you high because you have self-discipline with credit use – you could use more, but you don’t. There are no hard and fast rules here despite what you read; I suggest that people aim to keep a credit utilization of 20%, meaning use only 20% of the credit that’s available to you. If you have a lot of debt, always pay off the variable debt first and fast, as this can haunt you.
  2. Debt to income: this is a basic division problem where you divided the total amount of debt a person has by the total amount of their income. Conservative banks and lenders look for ratios of less than one, while other banks and lenders don’t mind ratios above one. As a note for people who like to invest, this is a key ratio to watch when investing as well – companies that want to borrow above their income level should generally be avoided.
  3. Payment history: how often do you make or miss payments? Banks and lenders know that your payment history can accurately predict whether you’ll default later and this can be a major concern for banks when issuing longer term loans. In some cases, payment history from non-credit sources can be used, such as medical bills, cell bills, etc; these also help banks and lenders assess risk.

You will find other assessments, but these do not apply to all institutions measuring credit risk – such as the reason for a loan, which is a popular topic that you can find online. Some banks care why you’re borrowing; others don’t. Likewise, you may apply for a collateral based loan and banks will need to know information about it, but this doesn’t apply when you’re looking for a secured loan. The key to keeping your interest rates low, using the above measurements, is always pay your debt on time, do not borrow too much from variable credit by maintaining a low credit utilization ratio, and increase your income if your debt is too high. The latter point of increasing income should be done regardless if you have debt: if you’re not working a second or third job when you have debt, you have no right to complain about financial problems. No easy path to a great future exists.

One interesting point here is that we live in the age of peer-to-peer lending which allows us to lend currency like US Dollars or bitcoin. If you’ve ever become a lender, you realize the other side of the borrower-lender equation and you will also learn why some lenders weigh people the way they do. Since I do bitcoin peer-to-peer lending a lot, I discuss my techniques for weighing borrowers in The Decentralized Retirement Plan and you’ll note they have some similar patterns to banks, but some major differences as well. Be careful about bashing lenders too hard – you may become one someday and realize why they weigh borrowers in strict manners. Many people who’ve done bitcoin peer-to-peer lending often lose many of their bitcoins.

Strategies For Killing Debt

A few years ago, one of my smartest colleagues, John, mentioned that he paid a company each month to help pay off his mortgage faster. I asked him how the company achieved this without making extra principal payments, and he responded, “I don’t know.” As we discussed the details, I learned that John didn’t understand how mortgage interest was calculated based on principal, and I realized that the company who sold this product had learned that they have a full market of people who are completely unaware that making extra principal payments each year, especially early in the year, will result in the mortgage being paid off faster. This technique is not limited to mortgages: if you want to pay off any loan faster, extra principal payments will do the trick. The more money you pay into the loan or line of credit early, the less interest you’ll pay over the life of the debt.

Most people forget what debt is: you are borrowing from the future to pay for the present. If you do this, you should not be rewarding yourself, as the very nature of debt is dangerous – you nor I control the future and hoping that your future is better when your present doesn’t cover what you need is foolish. In the conclusion, I make note of the example of John D. Rockefeller who used debt to build Standard Oil and show why his case, and a few others, are different than what I am writing here. People love to think they are like that – “I’m borrowing for a good reason, like a house” – wrong, you’re not. Borrowing is never a good choice, unless the return you receive from the funds reduces the cost of borrowing through a short time period. For this reason, the first strategy to eliminating debt is you must increase the pain of your present, since you are borrowing from your future. In American speak, that translates into “You must work a second or third job.” If you won’t increase the pain of your present, you don’t deserve to borrow from your future – we’re balancing the weight here. Again, debt means pain in the future and that pain must be balanced.

Next, cut the waste. If you borrowed money to buy stuff you never use, sell it. People have many options here – garage sales, eBay, etc. Buying stuff for no reason, or “maybe I’ll use it someday” doesn’t enhance your life if you made the purchases with debt, and this last point is key. If you want to buy extra resources with money that you saved because you may need it, that’s not foolish at all, as you are living within your means. From reviewing credit cards from hundreds of thousands of customers in the past, most purchases do not need to be made.

You will also need to defeat retarded “pop pyschology” which destroys most people’s lives without them evaluating the effects of it. When people want something, they often look for rationalizations to obtain it immediately without waiting and these rationalizations lead to destructive behaviors, such as debt. One of the most popular “pop psychology” rationalizations that I saw while working for the bank is the “I don’t believe in living within my means because that limits who I can be!” The irony of the people who said this was that fewer than 1% expanded their means from debt, but expanded the bank’s means. Simply put: most people like to think that they’ll be the responsible one with debt, when they won’t, and it will end up costing them a huge amount of money and time in the long run. If you successfully defeat the “I’m the exception to that rule” mentality in life, you will go far because the actual exception to the rule recognizes that they are not an exception. Here are some popular statements I’ve heard that rarely result in anything productive – be on the look out when you say these statements to yourself:

  1. I want to live in the present and enjoy now. Ask: how does debt avoidance prevent this?
  2. I worked hard today, I deserve something special. Ask: compared to whom? The Chinese work 70 hours a week still save a third of their income.
  3. This debt will only be this one time because of [x] reason. Ask: what’s preventing me from working a second job, more hours, or selling goods to fund this [x] reason?
  4. I don’t want to limit myself. Ask: why am I not applying this same logic to doing – shouldn’t I do more instead of borrow more?

Make no mistake, the same people who complain about debt and how it hurt them under no circumstance would respond responsibly to the above questions – they rationalized their behavior, it failed because 99% of the time it will, and they blamed everyone else but themselves. While shouldn’t surprise any of us, I make this note to help readers decipher the real truth when people complain about debt – their receiving the result of their poor choice. Make no mistake – and this applies to me as well – we cannot fool reality and if we won’t devote ourselves through work to our present, we will eat the bread of destruction in our future.

Consumptive debt is completely irresponsible and should be avoided; if you’re in consumptive debt, you should work an extra job at minimum and pay off your debt as quickly as possible. Investment debt – by contrast – needs an honest assessment. How well do you know the market that you’re borrowing to invest funds? For instance, let’s suppose that you’re a metals investor and you know that the price of copper is about $2 a pound, but that’s nearing the lowest point that it will land; how well do you actually know this market? What makes you assume that copper can’t fall to $1.50 or lower? Also, at what point will you accept a loss if you’re wrong and liquidate? Make no mistake, some of the smartest hedge fund managers were buying oil at $100 a barrel right before its precipitous fall and even Warren Buffet didn’t see the collapse in oil coming in 2014. No one is as smart as they perceive themselves to be; all you can do is look at a history of what you borrowed, how much you made, and in what what period of time – the longer it takes you to generate a return, the more interest you pay and the lower your return. Investment debt that generates a quick profit turn around reduces your total cost; nothing else.

Conclusion

In this article, I strong suggest that readers avoid debt. You will find thousands of articles on the internet about why debt is good or acceptable and many of these articles simply mislead you. Some of my friends have pointed out correctly that John D. Rockefeller borrowed money early in his business and this is true – he did. There are some keys to Rockefeller’s borrowing that separates what most people are doing:

  1. Rockefeller paid his loans very early, often within a few months – even though the loans were longer term. This leads to point number two.
  2. Rockefeller was making money so fast that for every dollar invested that one could argue it would have been irresponsible for him to wait; for an example, for every dollar he invested, within a couple of months that one dollar became $12-15. That’s like buying a dollar with a nickel – and if someone knows that’s their return and isn’t boasting, it would be irresponsible not to borrow.
  3. Rockefeller saved – a lot; the man had a notorious amount of self-discipline long before he went into business for himself. When I see people who’ve never sacrificed compare their business idea to Rockefeller, they’re deluded; if you can honestly look at your own behavior and see a huge amount of sacrifice in your life and know that your return will be strong, that’s one thing. This doesn’t apply to most people.
  4. Rockefeller, like my best peer-to-peer borrowers, communicated frequently with his lenders and his lenders loved him. Most borrowers hate banks because they don’t understand why they’re being charged interest and they don’t investigate what this means. Rockefeller was the opposite of this – he didn’t trash on banks at all. In other words, Rockefeller wasn’t looking for handouts.
  5. Rockefeller didn’t need debt, and this also demarcates a major difference. Needing debt puts the borrower in a bad position.

Those five items don’t apply to most borrowers. Borrowing, for most people, is not the responsible action to take.

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