The Double Whammy of Debt

It is important to realize how debt affects your net worth. The classic Net Worth formula is:

Net Worth = Assets – Liabilities

Liabilities are your debts. These debts reduce your net worth; especially "bad debt". Good debt is used to purchase assets that increase in value, while bad debt is used on assets that decrease in value.

Although we have here classified debt as "good" and "bad", all debt immediately decreases your net worth. And, you are also responsible for paying interest, which reduces the amount that you could be saving! This is a double whammy!

So, debt should not be used if at all possible. A home loan is the only debt that you will probably NEED to have. An education would also be an asset that would increase in value; however, debt should still be avoided if possible. In extreme circumstances, debt should only be used to purchase assets that will increase in value. The person, that pays good old cash for a car, education, furniture, electronics, and other items; will up with more peace of mind and usually more money in the bank.

Your credit cards and other debt should not be used to purchase groceries, gas, TVs, or other consumer goods.

However, in today’s world credit cards are so readily attainable and so convenient to use, it can be extremely easy to let your debts get out of control.

The Cause of Debt

In the days of our parents or grandparents, credit cards were rarely if ever used. Now the use of credit cards for basic items such as food and utilities is commonplace. Some other reasons that may be causing the high credit cards bills of America:

Loss of a job
Divorce
Excessive medical bills
Compulsive spending
Lack of financial knowledge
Lack of budgeting and planning

Nearly all debt problems fall into these categories. Unfortunately, most debt problems are caused by the last 3 and not the first 3.

The Solution of Debt

The first solution to debt is to stop accumulating more of it! Stop using your credit cards and start paying with cash or a debit card. This will allow you to stop the bleeding of money and begin to heal the debt wounds that you may have. Here are a few tips to eliminating your credit card spending:

Pay cash
Keep a written record of any credit card spending and pay it off before the end of the month.

Limit the number of credit cards that you have (this will also improve your credit score).

Don’t accept credit cards offers at retail stores just because of a discount or low introductory rate.

Don’t cash checks that you receive in the mail (from banks or other institutions).

Most importantly, start a budget…and stick to it! Frequently review how much you are spending and make sure not to buy anything on credit. Credit cards not only make you spend more (because of interest) on everything you purchase; it also prevents you from investing that money elsewhere.

For example, let’s take a look at Joe and Tammy. Both Joe and Tammy purchased the exact same TV for $1,500. However, Tammy had saved up for the purchase and paid cash, while Joe bought it the first time he saw it and used the store credit card he was offered at 22% annual interest rate. At $50 a month, it took Joe 4 years to pay for his TV.

While Tammy paid $1,500 for her TV, Joe paid a total of $2,200 ($1,500 plus interest over 4 years). So, Joe not only paid $700 more for his TV than Tammy, he also lost the opportunity to invest the $700 that he would have saved had he planned ahead.

Unfortunately, impulsive buyers do this over and over again and they end up paying thousands and thousands of dollars more for the same items that their neighbors saved up and bought.

For a continuation of this article, and a more detailed look at how to get out of debt and improve your credt, please see the resources below.

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Spencer has a BA in Finance, an MBA, and is currently a Commercial Banker advising Business owners on Business and Personal financial issues.