On High-Interest Debt
High-interest debt is the easiest thing in the world to acquire—like the common cold, except even easier. Maybe you picked up a free T-shirt at that college welcome fair freshman year and acquired your credit card to go with it. Or you signed up for 50,000 airline mileage points at the airport kiosk. Either card will be charging you 25% interest before you even blink.
As an experiment I once walked into a payday lending shop in my hometown and walked out 25 minutes later with $200 cash. It was so darned easy! Until I paid $50 in interest a month later, or 25% monthly interest.
If you walk onto a car lot with little cash and no credit history, maybe you’ll get a subprime auto loan for a 13% annual rate.
You don’t have any cash for clothes at the dress shop, renovation supplies at the hardware store, or $500 for Fluffy’s deworming medicine at the vet? All of these places can provide you with high-interest cards if you’ll just sign right here on the line. You might even get $10 off when you sign up!
I’m starting with high-interest debt because the order of presentation in this book matters tremendously to me. First things first, next things next, last things last.
High-interest debt is the first topic for this “starting out” section because if you don’t work on this first, nothing else matters. You cannot build wealth and also maintain high-interest debt balances. Full stop.
Good News, Bad News
I’ll describe the bad news problem with high-interest debt in more detail later in the chapter, but guess what the silver lining to living under a dark cloud of high-interest debt is?
Dramatically improving your personal financial situation—if you have high-interest debt—remains very, very, simple at this point. Everything you need to know right now about fixing your finances is right here. You don’t need to read beyond this page in this chapter. Right now, you can put down this book and just work on your single, simple plan.
Pay down your high-interest debt.
So simple. With high interest debt, you’ll never get wealthy. Take care of your high interest debt, however, and you’ve at least got a fighting chance at building wealth.
So easy, right? Well.
How you do it, as a practical matter, is indeed simple, but far from easy.
We’ll talk about some useful techniques in Chapter 7 on saving, and some tax considerations in Chapter 9 on retirement accounts, and Chapter 12 on homeownership. I’ll return to those ideas at the end of the chapter to be a bit more nuanced in my advice. But really, you only need to understand one big thing: pay down all high-interest debt to zero.
High-Interest Debt Taxonomy
What are the various kinds of high-interest debt, and how will you know if you have any?
Here’s a partial list of mainstream high-interest debts, although high-interest lenders are so darned creative there will be other kinds of expensive loans not mentioned here.
Payday loans: Possibly the most egregious of legal high-interest loans. Structured for just a few weeks to 3 months, the annual interest rates on these advances against your paycheck can reach over 100%.
Pawn shop loans: Collateralized by some valuable item you own, these 60- to 90-day loans can also have an annual rate of over 100% per year.
Car title loans: With high monthly interest and the rights to your car as collateral, these reach above 100% annual rates per year.
Tax advance loans: “Tax preparation” companies help figure out your income tax refund, then lend you the money while you wait for the IRS to send it in the mail, for the equivalent of a very high annual interest rate. They only lend you money for a few weeks to a few months, but the equivalent annual rate will be very high.
Credit card balances: While you may briefly get 0% teaser rates, eventually the companies know the cost of you carrying a monthly balance will approach the average 12% rate. This can easily shoot up to the legally allowable 29.99% annual rate.
Subprime home loans: At many percentage points higher than conventional prime mortgages, this is an expensive way to buy a house. You need to work toward a lower-cost prime loan instead.
Subprime car loans: Many car dealerships are built on profit from selling high-interest car loans more than actually selling cars. Car loans can be very affordable if you have good credit, but many subprime loans are very expensive.
This is only a partial list of the most common and legal ways in which you might be paying way more to borrow money than is compatible with building wealth.
Is All Debt Bad?
Now, nestled in the title of this chapter is a key distinction about personal debt to which I’d like to call your attention.
Notice I’m calling out a difference between high-interest debt and low-interest debt.
I believe deeply in this difference.
In brief:
High-interest debt = not compatible with building wealth.
Low-interest debt = compatible with building wealth.
Not everyone agrees with me on this point.
A popular and well-known personal finance guru, for example, insists that his followers eschew all debts and pay for everything with cash. All debt, he insists, will keep you poor. Any debt, he implores, keeps you from getting wealthy. For him, the best way to buy a car or a house is to save up all the money in cash first. Years later, when you have the money, you can make your purchase.
I disagree with this guru.
Look, he’s a little bit right but quite a bit wrong.
He’s right that for some people, debt can get out of control. Debt becomes a compulsion and a crutch, and ultimately a crushing weight.
For the recently bankrupt or the perennially broke, all debt hurts.
Debt Is a Drug, for Both Good and Evil
But for many of us, debt is a complex mixture of danger and opportunity. In that sense, debt is a drug. Like prescription pharmaceuticals, debt can be life saving—or at least life enhancing—for some. That same debt drug can be devastating to others. If you’ve had trouble with the debt drug in the past, you may not be able to handle even a drop, whether of the high- or low-interest variety.
But if you’re not susceptible to that particular addiction, low-interest debt can help you achieve many life goals, including especially, wealth building. I return to that theme in Chapter 8.
When do you get stuck with high-interest debt, instead of low-interest debt?
When you can’t get a prime loan. So what does a prime loan mean? A prime loan has the lowest rates and the best terms available to borrowers.
You can qualify for a prime loan with a FICO score of 720 or better. I’ll describe more about FICO scores in Chapter 8, but for now the important point is that when you don’t have a prime loan, you get something punitive in the form of high-interest debt.
High Interest, Fees, and the Terrible Irony of Being Broke
Life is not fair, and high interest loans and fees are one of the unfairest parts of financial life. The less money you have, the more lenders will charge you. In that sense, lenders kick you when you’re down. It’s the truth.
When you have subprime or high-interest loans, the interest rate isn’t the only thing you’ll pay extra for. You’ll also end up paying extra fees, penalties, origination fees, or “points” to get your high-interest loan, which makes borrowing even more expensive than the stated interest rate.
A well-known comic made this point a little while ago in a hilarious, awful, and true description of dealing with his bank when he was broke. I’ll paraphrase his monologue:
Bank: “Uh sir, do you know you have insufficient funds in your checking account?”
Comic: “Yes, I’m aware, I don’t have any money. But, that phrase ‘insufficient funds,’ yes, that’s a nice way of putting it. I’m fucking broke.”
Bank: “Well, we’ve had to charge you $25 because you only have $15 in your account and you attempted to—”
Comic: “Wait, you just took $25 from me, simply because I only had $15?”
Bank: “Yes, you see, sir, you had insufficient funds.”
Comic: “Ok, yes, obviously as you say I don’t have any money, but you took the little bit I did have, just because I don’t have enough? And now that means I have less than zero dollars in my account. I have like, negative $10?”
Bank: “Yes, sir, because of your insufficient funds.”
Comic: “But that means I can’t even afford something that costs me zero money. Like, if somebody offered me something for free, I’d have to say, sorry, I don’t even have zero dollars. Your free thing costs me zero dollars? That’s too much. I can’t even afford that much.”
That’s a tragicomic and accurate description of the way lenders treat people who don’t have enough money. You pay extra, which seems like punishment for not having enough money in the first place. Which is awful. And true, because life is not fair, especially financial life.
You want more truth about the unfairness? Many lenders don’t really want to “cure” your situation, because charging lots of extra “insufficient funds” fees as well as high interest on your debt can be quite lucrative for them.
For some lenders, charging those insufficient funds and late fees and high interest rates is the main business model for their profitability. In software programming terms, your bounced checks and late fees for them are a “feature” not a “bug” of their loan to you. They’re charging you more money because you don’t have enough money. With high-interest debt you are on a fast-moving treadmill designed to exhaust you, and you cannot win.
And even more truth: only you can cure your situation.
The cure is to pay off the debt, and to, over time, zealously guard your credit score so that you can qualify for low-interest debt.
Low-interest debt, as I’ll explain in more detail in Chapter 8, doesn’t prevent you from getting wealthy, and may actually be helpful to your wealth-building process.
Compounding Effect of High-Interest Debt
So how do I know there’s such a big difference between high-interest debt and low-interest debt? Really, how do I know you cannot get wealthy if you carry high-interest debt, but you could get wealthy if you have some low-interest debt?
I know because I wield compound interest math like a ninja, and after reading Chapter 4 hopefully you do, too.
Let me introduce you to an elegant illustration called the Allowance Experiment that I learned from Andrew Tobias, author of the excellent The Only Investment Guide You’ll Ever Need.1
Since you’ve mastered the lessons of Chapter 4 on compound interest (right?), you can follow right along with the math of the Allowance Experiment.
I actually did the allowance experiment with my eldest daughter. I presented her with two glass jars, each with one dollar already in it. I told her I agreed every day to add to the first jar an amount equal to 10% of whatever was in glass jar 1. I explained that in this way I would represent for her an optimistic view of how money wisely invested could grow over the long run.
(Just between you and me, 10% is probably too aggressive an annual return for ordinary investing over 35 years, but it has the virtue of being a nice round number. It is also not impossible as a long-term return. Including the reinvestment of dividends and price appreciation, the S&P 500 stock index compounded above 10% over the past 40 years.)
Because this ends up as a reasonable amount of money, I agree that this will be her allowance for the next 5 weeks.
I then tell her we will track how banks charge interest on credit cards, which can be 20% or more. To track that, each day I will add an amount equal to 20% of whatever is in glass jar 2.
The point here is to illustrate the difference that compounding interest makes—the difference between 10% and 20%—when you compound the effects over time. This is my way of teaching how the long-term effects of high interest are just too destructive for your wealth-building project.
I had her record in her journal the amount to add each day.
In jar 1, on day 1, that’s a dime. Day 2, I put in 11 cents, because there’s already $1.10 in the jar. Day 3, there’s $1.21, so I add 12 cents. Each day I add 10% to the total, as her allowance, and I do that for 35 days.
You remember from Chapter 4 that I can figure out the total amount that will be in the jar using the formula FV = PV ∗ (1 + Y)^N, where PV = $1, Y = 10%, and N = 35.
In jar 2, in the 20% high-interest jar that mimics credit card rates, we also start with one dollar.
I agree to put in 20% of the amount in the jar. So day 1 I add two dimes, because that’s 20% of a dollar. Day 2, we’ve already got $1.20 in the jar, so 20% of that is 24 cents, which I drop in the jar. On day 3 the high-interest jar has $1.44, so I add in 29 cents. I also do this for 35 days.
Again, remembering the formula for compounding from Chapter 4, we can figure out the total amount that will be in the jar after 35 days using the formula FV = PV ∗ (1 + Y)^N, where PV = $1, Y = 20%, and N = 35.
After 35 days the 10% allowance jar will have $28.10. Which is a lot, considering we started with a just a dollar and simply compounded at 10% per day. My daughter got to keep that, because I am a nice daddy.
After 35 days of compounding at 20%, however, the high-interest jar would have $590.67 in it.
Which is a whole other order of magnitude. The amount in the 20% interest rate is not around two times as much as the 10% jar, as you might casually and incorrectly guess without thinking too much about it.
It’s 21 times as much money. My daughter did not get to keep that, because I am a nice daddy, but not that nice.
A credit card lender, which can certainly charge you 20% or more on your high-interest debt, and then continuously reinvest the payments it receives every year in other high-interest loans, could conceivably grow its original one dollar into $590.67 over 35 years.
Obviously, I’ve simplified the credit card business considerably to illustrate the long-term difference in interest rates.
Just as obvious, I hope, is the fact that when you agree to borrow money and pay high interest rates, you agree to make your lender rich and yourself poor.
Appendix
I’d like to qualify what I said in this chapter about utter simplicity—specifically the idea that you can forget everything else there is to know about personal finance, if you have high-interest debts and singularly focus on that problem.
If you have high-interest credit card debt, for example, should you only pay that down, or maybe should you do other things like contribute to your retirement accounts or buy a house?
Well, maybe. I’ll allow for a bit of nuance.
From a pure finance standpoint—meaning taking into account just the numbers and mathematics of the case—focusing purely on paying down your high-interest debt usually makes the most sense.
What I mean by that is that if you carry a credit card balance on which you pay a 20% annual rate per month, the pure math suggests that you pay that down to zero before, say, contributing to an investment account, where you should not expect to beat a 20% return on investment. With this pure math perspective, it makes no sense to pay 20% on a $5,000 balance (paying $1,000 in interest per year), while earning say, an average 6% return on your $5,000 investment (earning $300 per year). You’re $700 poorer at the end of the year, obviously.
Two factors make the decision a bit less clear than that, however.
One factor is psychology. The second factor is the possibility of a company match in a retirement account, and the tax advantages of retirement savings.
I’ll take these one at a time.
Psychologically speaking, your mountain of high-interest credit card debt may seem so high right now that you neglect to make other important wealth-building decisions. And if you delay certain decisions such as contributions to a retirement account indefinitely, then you may “never get there.”
Again, the numbers don’t necessarily support this thought—we’re in the mushy realm of human psychology—but wealth building is not a purely numbers-based challenge. Maybe, possibly, small steps toward things like homeownership and retirement investments—even while still trying to address your high-interest credit card debt—can improve your chances of homeownership and having enough when you retire.
The Richest Man in Babylon Formula
One of the wisest books on personal finance—George Clason’s The Richest Man in Babylon—posits a simple formula that may be helpful to you, if you have high-interest credit card debt.2 Clason advocated living on 70% of your take-home pay, allocating 20% of your income to paying your debts, and then setting aside 10% to “pay yourself,” meaning savings and eventually investments in retirement accounts, and saving to buy a home. The long-term effect of this is that even while you pay down your high-interest debts you are setting the foundation for long-term wealth building. By the time your debts get fully blasted away, you’re well on your way to the next important goals for wealth. Like I said, I’m not convinced the pure math supports Clason’s advice, but I do think the psychological effect may outweigh the numbers.
Even if the math isn’t totally clear, parts of it are compelling, so I’ll hum a few more bars on the math.
The Company Match
When it comes to contributing to a retirement account instead of paying off high-interest debt, a few factors work in favor of contributing to retirement accounts while allowing your mountain of high-interest debt to continue to exist a bit longer.
First, if you have access through your job to a 401(k) or 403(b) retirement account (more on these in Chapter 9!), some employers offer free employer matching funds for a portion of your retirement account contributions. As an employee making a contribution, this is nearly the only known instance in the universe of “free money” for you. Since free money from your employer is an instant, guaranteed, 100% return on your investment, it can make mathematical sense to contribute to an employer-matched retirement account instead of paying back even your high-interest credit card debt. How much should you contribute in this case? The clear math would suggest that you contribute at least as much to your retirement account as is necessary to take full advantage of an employer match.
(Parenthetically speaking, payday loans at above 100% annual interest rate are another, less-attractive story. Pay those down to zero first, no matter what.)
Tax Effects and Personal Net Worth
The tax advantages of retirement accounts also muddy the previously clear waters a bit. If you earn money in a 25% income tax bracket, for example, your contributions to a 401(k) or 403b or traditional IRA account provide an immediate 25% annual “return” on your money, since you don’t pay taxes on any qualified amount you contribute to one of these retirement accounts.
Perhaps an example will help illustrate this.
Let’s say you have $10,000 in high-interest credit card debt, charging you 25% per year in interest. That means you’re obligated to pay $2,500 every year in interest just to carry that balance.
Now let’s also say by happenstance you managed to get an extra $13,333.33 bonus this year. The choice you face is between paying off your high-interest credit card debt and/or funding a retirement account.
Choice 1: You take your bonus, subtract out the 25% federal income tax rate on your earned income, and you’re left with exactly $10,000, just enough to pay off the high-interest debt entirely. That will save you $2,500 per year in interest charges, which would be awesome. You wouldn’t have any money left over, but the boost to your future take-home pay from not making future credit card interest payments should help improve your lifestyle from here on out.
Choice 2: You could elect to contribute some of that bonus to your retirement account. To keep the math easy, for example, let’s say you contribute $3,333.33 to a retirement account, leaving you with an after-tax take-home pay of $7,500, because the federal government claimed 25% of your post-contribution bonus of $10,000. Remember, after contributing to your retirement account, you end up paying taxes on only the extra $10,000 earned, not the full $13,333.33 bonus.
Now, $7,500 isn’t enough to fully pay down your credit card debt, but it’s a lot.
The after-tax result of choice 2 is that you’d take home $7,500 with which you pay down your debts, you’d pay $2,500 in federal income taxes, you’d still owe $2,500 on your credit card balance, and you’d now have an additional $3,333.33 in your retirement account. Because of the tax advantage of a retirement account, your net worth is $833.33 higher under this second scenario—making a retirement account contribution—than it would have been had you only paid off your high-interest debts with your bonus.
Your higher net worth comes at a cost, of course. You’re still on the hook for an interest payment of $625 next year, because that’s 25% of the remaining $2,500 high-interest credit card balance. While you cannot expect your $3,333.33 in retirement investment to generate the equivalent of a 25% return to keep pace with the high interest you owe next year, still the increase in net worth, plus the psychological effect of a greater net worth could make this an attractive—or at least plausibly responsible—use for your money, instead of simply paying down high-interest debt.
Furthermore and remember, if your $3,333.33 retirement account contribution in choice 2 qualified for employer matching funds, then the net worth advantage of choice 2 looks even better.
So like I said, simple still works when it comes to the overwhelming goal of paying down high-interest debt, but a little bit of nuance can be OK, too.
1Andrew Tobias, The Only Investment Guide You’ll Ever Need (New York: Mariner Books, 2010), 225–228.
2Some people swear by George Clason’s 1926 classic book on indebtedness, savings, and compound interest, and certainly for memorable faux-babylonian parables and simple storytelling, it’s a winner. George S. Clason, The Richest Man in Babylon (Reprint Edition by Dauphin Publications, 2015).