Compound interest is the eighth wonder of the world.
He who understands it, earns it… he who doesn’t… pays it. — Albert Einstein
In 2014, American consumers had a gargantuan total of $11.7 trillion dollars in outstanding debt. Fortunately, most of this debt was on things like mortgages and student loans.
Still, Americans had $882.6 billion in credit card debt, which amounts to $15,611 per household, which is a lot.*
The principle of debt is rather simple: borrow money now and pay it back in the future, with interest. Thereby, anything bought with debt will cost more than it would have otherwise.
And, with credit card debt, it’s a lot more. Something you bought for $100 today will cost $115.68 next year. When it all boils down, there are, generally speaking, two types of debt.
The good kind allows one to make a return (financial or otherwise). So, mortgage debt used to purchase a house would often qualify as good debt because houses will, in the long run, appreciate.
Debt for starting a business or purchasing an investment vehicle can also be good, since the goal is to make more than the cost of repayment.
Student loans can be good debt, too, because we invest in our earning potential and/or personal improvement and fulfillment. Other debts, such as those to pay for medical expenses and the like, may not be good, but they are necessary.
That being said, virtually any debt on a depreciating asset, or something that doesn’t allow us to grow as individuals should be qualified as bad debt. Patience is a virtue, and a lack of patience is quite expensive. It’s what economists call time preference.
Effectively, an individual’s time preference is the relative value placed on a good now versus at some point in the future. The less time you’re willing to wait, the more you’ll end up paying because of the interest that will accumulate during that time.
Rent-to-own televisions, computers and even cars are simply transfers of wealth from the impatient to the patient. Bad debt means you are obligating yourself to work in the future to pay off whatever you’re buying today.
Why make such obligations?
The work you do should pay for the present and build a nest egg for the future, not just allow you to pay off something you’ve already used up. Behind all of this is, perhaps, the greatest key to success in life: the deferral of gratification.
In the famous Stanford Marshmallow Experiment, young children were given the option of eating one marshmallow immediately or waiting 15 minutes to get two. Most children quickly succumbed to the temptation of the marshmallow and deprived themselves of the second.
Only about one-third of them were able to hold out for the second marshmallow.
Many years later, the researchers evaluated how well the students did in life, and those who waited for the second marshmallow did substantially better than those who had not, on a wide range of factors.
The children who were willing to delay gratification and waited to receive the second marshmallow ended up having higher SAT scores, lower levels of substance abuse, lower likelihood of obesity, better responses to stress, better social skills as reported by their parents, and generally better scores in a range of other life measures.
And, the results of this study have been repeatedly replicated. The ability to delay gratification is universally regarded as one of the most fundamental skills a successful person can have.
And, thereby, it’s one of the most important skills to nurture in yourself. The moral of the story is simple: Consumer debt represents the first marshmallow.
And, yes, with the smorgasbord of cool, new consumer products deftly marketed everywhere, and massive companies willing to throw billions at advertising, such temptations are plentiful.
But, it is a dangerous and backwards game to play.
In the end, building a nest egg and having enough disposable income to do what you would like in life involves saving money, not paying through the nose for things that will become all but worthless by the time they are paid off.
Even a new car loses more than 10 percent of its value the moment you drive it off the lot!
And, the more bad debt a person has, the worse his or her credit score will be (and, the more likely he or she is to default), making it that much harder to acquire good debt and get it at a good interest rate.
I strongly recommend splitting debt into the good and bad categories and leaving the bad type for good. Make it a rule instead of a recommendation.
Going into debt because there’s no other choice is one thing; otherwise, debt should only be used as an investment. Even auto loans should be avoided, if possible.
Bad debt, which includes virtually all consumer debt, leaves you running, just to stay in the same place. Avoid it like the plague.
*As of January 8, 2015, the average interest rate on a credit card was 15.68 percent, making it one of the most expensive forms of debt around. And, unfortunately, it’s a type of debt that many people don’t think twice about.