As I mentioned, growing up the way I did taught me a lot. There was one part of my cultural background that came in especially handy: statistically, Chinese citizens have an average savings rate of 38 percent.1 That is massive compared to the American rate of 3.9 percent and the Japanese rate of just 2.8 percent. What’s going on here? Is Chinese culture just naturally more frugal than others?
I went to my best source: my dad. He said that even before the Communists came to power, government corruption was so common it was just a way of life. Whenever someone did you a favor or lent you something, you were expected to repay them, either through political favors or with money. Over time, it became ingrained in the national psyche that being in debt to someone gives them power over you. (During Chinese New Year, you have to settle any debts and start with a blank slate—or be cursed with bad luck all year.)
Admittedly, this is the definition of anecdotal evidence, but there are other explanations. First of all, debt was not available to the Chinese for most of our country’s history; the first credit card wasn’t even introduced there until 1985.2 Compare this with the Western world, where credit cards came to the market in 1950.3 When I was growing up, the concept of credit was completely foreign to me. I didn’t know what a credit card was, had never heard of a bank loan, and had no clue how a mortgage worked. If my parents wanted a big-ticket item, like a bicycle or a watch, they saved up. Buying on credit and paying it back later wasn’t an option. You simply had the money to buy it or you went without.
Second, due to the lack of a social safety net in China, we have always had to fend for ourselves. Education, health care, retirement? It was all up to us.
Finally, the expectation of catastrophe was drilled into my parents’ generation, and that mind-set—that shit can hit the fan at any moment—defined how they saw the world. The idea of relying on the government was laughable. The government’s job isn’t to help you! Their job is to find new and creative ways of making your life immeasurably worse.
This all taught me that debt had to be avoided at all costs, and that if I wanted something I’d have to earn it. I didn’t get a credit card until after I graduated from college. At work, I would sit back and watch as my friends and coworkers went nuts with debt, spending money they hadn’t earned, while patting themselves on the back for being fiscally responsible by buying the basic Tesla model instead of the one with all the fancy features.
I’ve since realized why debt is so destructive. Debt removes the link between time and money. And when that happens, people start making bad decisions that blow up their finances.
Einstein is supposed to have said, “Compound interest is the eighth wonder of the world.” As you earn and save, your money makes more money, and that money makes even more money. Literally every finance book available talks about this, and all agree that it’s a Very Good Thing.
But what’s if it’s not a Very Good Thing? What if it’s a Very Very Bad Thing?
I’m sure everyone’s heard that E = MC2. Allow me to introduce you to Luca Pacioli’s Rule of 72.
Here’s how it works. If you know the return you’re earning on an investment (say, 6 percent per year), divide 72 by that number (72 / 6 = 12). This gives you the number of years it’ll take for your money to double. If I invest $1,000 with a return of 6 percent a year, it’ll compound into $2,000 in 12 years without my investing another cent. That balance goes up over time, because the money I make makes more money, which in turn makes even more money.
When you’re an investor, the Rule of 72 is your friend. It helps your money grow. But if you have debt, the Rule of 72 is your enemy. It works against you to take what little money you have. Credit cards typically have interest rates around 20 percent, so if I borrow $1,000 to buy a flat-screen TV, it would take only 72 / 20 = 3.6 years for my debt to double. Another 3.6 years and the debt quadruples.
This is why debt is so scary. If you don’t kill it, the debt monster gets bigger and bigger until it’s consuming everything in its path.
Don’t let the monster get that big. We have to slay it now.
Another reason debt is so dangerous is because debt distorts the value of money.
Back in China, when my parents didn’t have money, they couldn’t buy anything. There were no credit cards, no lines of credit, nothing. If they couldn’t afford something, they simply didn’t get it. And you know what? Thinking back, it’s a decent system. Nowadays, every idiot and their cat can get a credit card. And when they do, it’s so easy to forget how precious money is.
Because money is a stand-in for time.
In order to buy a $100 watch, my parents would have had to earn each dollar through manual labor. At the rate of 44 cents a day, the amount they got paid, it would have taken them 228 days—and that doesn’t consider funds set aside for food, clothing, and basic living expenses. One TV would have required at least a year of work.
Debt changes all that. Debt allows someone to get that TV right now, using money that seemingly appeared out of nowhere. Down the road, that TV will cost double or more, but that’s a problem for Future You. Present You is busy enjoying their brand-new TV!
By disconnecting money and time, debt screws over your future self.
These days, Americans owe $13 trillion4 and Canadians $1.8 trillion,5 and it’s no wonder. When the value of things we purchase is no longer tied to the number of hours we had to work for them, it’s easy to take this “funny money” and blow it. The problem is, eventually Present You will become Future You. And then what are you going to do?
First, do whatever you can to avoid going into massive debt. It’s the worst financial mistake you can make. That being said, a lot of us are already far down that road and trying to make our way back to financial freedom. What are we supposed to do then?
Glad you asked.
When it comes to types of debt, consumer debt is by far the worst. It’s a blood-sucking vampire. Not only does it bleed you dry, it makes you terrified of the sun by trapping you indoors, shopping for crap you don’t need, and/or shackled to your desk for years.
Since consumer debt has the highest interest rate, you want to slay this bad boy first. Consumer debt should be treated as what it is: a financial emergency that you have to take care of now. Here are a few things you can do to sharpen your stake.
1. Cut expenses to the bone, even if it hurts. Consumer debt has the highest interest rate of all and, as per the Rule of 72, doubles faster than any other type of debt. You need to treat this as a crisis. There is absolutely no point in investing or even saving much cash if you’re carrying debt with a 10–20 percent interest rate. Paying it off should be your number one financial priority. If you need to get a side gig or a roommate, or learn to say no to dinners out, do it.
2. Order your loans based on interest rate, highest to lowest. If you have several vampires at your neck, kill the one with the highest interest rate first. That one sucks the most blood and grows the fastest, making it doubly dangerous.
First, pay the minimum monthly payment on all of your cards to make sure you don’t go into default (which would make things even harder to deal with). Next, make the biggest stake ever (all the cash you can scrape together) and stab the nastiest bloodsucker (the one with highest interest rate) straight in heart. Paying off the smallest loan might make you feel better, but you’re trying to kill a monster here, not boost your self-esteem. Remember, your goal is to let the credit card companies take as little of your hard-earned money as possible—so you can invest it (which we’ll talk about in chapter 10) and taste that sweet, sweet freedom sooner.
3. Refinance your loan. Many credit card companies run promotions allowing you to transfer balances between cards and pay 0 percent interest for a set period of time, usually a year. These help you along by reducing your debt’s interest rate. Don’t simply transfer your debt around; do this only if you’re sure you can pay it off within that grace period. These companies are hoping you can’t, because then the interest rate skyrockets and you get screwed again. Be careful!
When readers ask me how to invest while they’re carrying consumer debt, I tell them they’re trying to run a marathon with a parasite on their back. There’s no point. You’ll run out of energy in the first mile. No matter how good the returns, the interest rates on your debt will immediately devour them. Slash your expenses and destroy that vampire first.
In terms of interest rates, student debt is the second scariest. Even though it typically carries a lower interest rate than consumer debt (4–8 percent instead of 10–20 percent), it’s the only debt you can’t discharge in bankruptcy—you can run and hide, but it’s always following, like that red ghost from Pac-Man. However, this is only true for Americans (there are complex rules for Canadians, but you can do it).
This is why it’s critical to figure out your POT score from chapter 4 before choosing a field, if possible. If not—if you’re reading this knee-deep in debt without a job that pays enough to help you out of it—you still have options.
Most student debt is held by the federal government, which has some advantages. Namely, it provides ways to reduce how much you owe each month if you don’t make enough money or unexpectedly lose your job. This doesn’t reduce the total balance, but it prevents you from defaulting, which would make the situation way, way worse. Using a payment reduction plan is like eating one of those white pills in Pac-Man: it doesn’t make the ghosts go away, but at least they stop chasing you for a little while.
There are four types of income-driven repayment plans.
REPAYE has the lowest barrier to entry and is the most forgiving income-driven repayment plan. It’s open to all graduates with federal direct loans, regardless of when you took out the loan. You are even eligible for loan forgiveness in twenty years for undergraduate degrees and twenty-five years for graduate degrees.
On this plan, the maximum you will ever pay is 10 percent of your discretionary income, which is defined as after-tax income minus 150 percent of the federal poverty level.6 At the time of this writing, if you’re single, the US poverty level is $12,140, so 150 percent of the poverty level is $18,210 ($12,140 × 1.5). If your after-tax income is $30,000, your discretionary income would be $30,000 − $18,210 = $11,790 per year, or $982.50 per month. Under REPAYE, your monthly payment would be limited to 10 percent of $982.50, or $98.25.
PAYE is an older version of REPAYE with more red tape. Generally, you are only eligible if you graduated college in 2012 or later. (This is because you can’t be a new borrower as of October 1, 2007, and have received part of the loan on or after October 1, 2011.) Like REPAYE, your monthly payment is limited to 10 percent of your discretionary income, and your loan is forgiven after twenty years.
IBR limits your payment to between 10 and 15 percent of your discretionary income depending on whether you’re a new borrower after July 1, 2014. Outstanding loans are forgiven after twenty-five years if they were taken out before July 1, 2014, and twenty years for loans taken out after that date.
ICR limits your payment to 20 percent of your discretionary income but calculates discretionary income slightly differently, as: After-Tax Income − 100% Federal Poverty Level. Outstanding loans are forgiven after twenty-five years.
|
Plan |
Payment Amount |
Forgiveness Period |
|
REPAYE |
10% of discretionary income |
20 years (undergrad), 25 years (graduate) |
|
PAYE |
10% of discretionary income |
20 years |
|
IBR |
10–15% of discretionary income |
20–25 years |
|
ICR |
20% of discretionary income |
25 years |
Remember, these plans don’t magically make the loan go away; they only keep you from defaulting if you aren’t able to pay them back at the moment. They do, however, make you eligible for loan forgiveness twenty to twenty-five years down the road, but we’ll discuss why this isn’t a silver bullet either. Each program has eligibility requirements depending on what type of loan you have, so contact your loan provider or go to StudentAid.ed.gov to see your options.
Let’s talk loan forgiveness. It sounds like signing up for a repayment plan is a no-brainer given that they have loan forgiveness options, right? Well, not exactly. In the United States, student loans that are forgiven are added to your taxable income, so while your loan may go away, a portion becomes an IRS debt. If you don’t have the cash to pay off that tax bill, you then have to negotiate with the IRS to see if you can get on one of their repayment plans or try to discharge the tax debt through bankruptcy—which could take years. You could easily be in your fifties by the time you get rid of that damned debt. See what I meant when I said that student debt is like the red ghost that just follows you around forever?
The big exception is the Public Service Loan Forgiveness program. If you work for a nonprofit or the government, the PSLF forgives all your debt after ten years of income-based payments, and that amount actually does go away. No surprise tax bill, just bye-bye, debt.
The strangest thing about this program may be how little people seem to know about it. Most folks think it only applies to charity workers, but many jobs qualify. Teachers are generally eligible since they tend to work for the state. Health care workers, too, if they work for a nonprofit hospital; ditto for academics at universities run by the state. If your employer has any connection to the government whatsoever, check with your HR department to see if you qualify. You can have any of these loans:
Federal Subsidized/Unsubsidized Stafford/Direct Loan
Federal Direct PLUS Loan
Federal Direct Consolidation Loan
Look closely. Even if you have the wrong type of loan, you might be able to consolidate it into a Federal Direct Consolidation Loan, and then all of a sudden, it’s eligible!
The really tragic thing about the PSLF is that in order to qualify, you have to make ten years of payments toward the right loan type. If you’ve been making payments on an ineligible loan, they don’t count toward the ten-year time frame. But if you work for a qualified employer, have a qualified loan (or consolidated it), sign up for one of the repayment plans above, and make your payments on time for ten years, it’s possible to get rid of your student loan once and for all.
If you’re Canadian, I’m happy to report that navigating your student loans is far simpler. The Canadian government has something called the Repayment Assistance Plan, which, depending on family income, will reduce the monthly amount you pay toward the loan. For Americans, if their reduced payment is less than the interest they owe, their loan gets bigger, but for Canadians, the government will pay any interest, preventing the loan from increasing. Additionally, your loan will be forgiven after fifteen years, with none of that taxable-income crap that the Americans have to put up with. It’s a federal program, so it’s available to everyone (cue “O Canada”).
There are also more-specialized programs, depending on your field and province. If you’re a nurse or family doctor, there are separate assistance programs for you. If you live in British Columbia, there’s one for you, too. And if you live in Newfoundland, you don’t have to pay it back ever, since they converted all their student loan programs into a grant-based system back in 2015! So, check with your province, and see what you qualify for. You may be pleasantly surprised.
Refinancing is your final tool. Refinancing transfers your loan from a public to a private lender, which can reduce your interest rate. Be super careful here, because once you do this, you lose the safety net of a federal loan, like the ability to lower your payments using income-based repayment programs, and your loan is still nondischargeable in bankruptcy! You also can’t have your loan forgiven through the PSLF. For this reason, I generally advise people not to refinance their student loans unless their job is super stable and, even then, to only refinance the portion that they can repay within a year. For example, if you’re a highly paid doctor with a whopping balance, and you can put $50,000 toward your loan this year, then go ahead: refinancing can help you save interest for the year while not sacrificing PSLF eligibility for your entire loan.
Last, but definitely not least, is mortgage debt. Mortgages are generally the heftiest and most common debt people carry in their lives, and while housing is way too big a topic to discuss here (we’ll deal with it in chapter 9), here are a few quick notes.
Because mortgages are secured against your home, the interest rates tend to be low. While consumer debt typically has rates of 10–20 percent, and student debt 4–8 percent, mortgages are as low as 3 percent. For that reason, it can make sense to not pay off a mortgage and invest instead, since even a conservative investment portfolio can make around 6–7 percent annualized.
We’ll cover both investing and housing later on, but for now, a rule of thumb is:
|
If a mortgage has an interest rate of . . . |
Then . . . |
|
< 4% |
Pay the minimum, invest the rest. |
|
> 4% |
Pay off the mortgage first, or refinance to below 4%. |
Getting into debt is one of the things that prevent us from living the life we want, because it can quickly snowball. While the best strategy is to avoid it in the first place, if you’re already in debt, these tools will help you get out of it before it destroys your finances. Sharpen that stake, and good luck.
CHAPTER 5 SUMMARY
Debt uses the power of compound interest against you rather than for you.
Credit card debt is the most dangerous category and should be paid off ASAP.
Cut expenses to the bone.
Pay off credit cards with the highest interest rate first.
Consider taking advantage of cards that allow you to transfer balances for a temporary 0 percent interest rate to give you some breathing room.
Student debt is the next most dangerous category because of how difficult it is to forgive.
Depending on the type of loan, you may be eligible for a payment reduction program such as REPAYE or IBR.
If you work for a nonprofit or a government agency, you may be eligible for the Public Service Loan Forgiveness program (PSLF), which will annul your loan after you make ten years of qualified payments.
Mortgages are the third type of debt most people encounter.
If your mortgage rate is less than 4 percent, pay the minimum and invest the rest.
If your mortgage rate is higher than 4 percent, pay down the mortgage before investing.