Wiser Financial Advisor – Debt Traps to Avoid
Hi, Everyone. Welcome to the Wiser Financial Advisor with Josh Nelson, where we get real, we get honest, and we get clear about the financial world and your money.
This is Josh Nelson, Certified Financial Planner and founder and CEO of Keystone Financial Services. We love feedback and we’d love it if you would pass it on to me directly at firstname.lastname@example.org . Also, please stay plugged in with us and get updates on episodes and help us promote the podcast. You can subscribe to us at Apple podcasts, Google, Spotify, or your favorite podcast service. Let the financial fun begin!
Glad you joined us today. We talk a lot about debt on this show and the reason is because so often people get themselves in trouble. Not with sophisticated investment strategies and things like that but with basic, foundational stuff when it comes to financial planning.
Debt is the enemy of growth. Too much debt—really any debt at all in the long run—is going to be an enemy toward you building wealth. That’s why we want to focus on debt and eliminate and avoid it as much as possible.
I don’t know about you, but when I was in college, I found that when I went in to get signed up as a freshman and showed up on campus, there were all these tables around with credit card companies trying to advertise and get you to sign up for their credit card. They would give you a free T shirt and things like that. Of course, everybody was signing up for credit cards. “Oh cool, free T shirt.” These are kids that are 18 and 19 years old that have no business having credit cards at that point. Nonetheless, they were very easy to get. At the same time, student loans were being offered and in a lot of cases the amounts on those loans were above and beyond what were needed. In fact, I remember getting my offer letter. I had applied for FAFSA and got it back. “Holy cow!” I thought. “Look at how much money they’re offering me here.” It was way more than I actually needed. And the reality is, I could have taken the money. A lot of my peers did take the full amount, thinking, “I don’t have to work in college, I can just have it all paid for.”
But of course, that had to be paid back eventually. That’s a big debate in society right now: “What should happen to all the student loan debt?” Personally, I worked my butt off in college so I wouldn’t have student loans. I borrowed just a little bit and paid it off as quickly as I could, so it rubs me the wrong way to hear that people may end up getting their student loans forgiven. But oh well.
When it comes to debt, I think a lot of it comes down to building financial character and starting as early as possible. Some solid financial habits and principles really are musts, both for us as individuals and for our families as well. It helps to be teaching our kids, our grandkids, and other people around us. I was lucky that my dad drilled into my head over and over that you should not owe money to anybody. In fact, I think he went a little far with that. (chuckle) My psyche is a little bit scarred by that idea to never owe money to anybody. Sometimes it can be useful, right? In short term situations, that is, but in general it’s good to have no debt. Well, except for a mortgage. We do treat a mortgage differently just because it is the loan on an appreciating asset. It’s something you can use to be able to get a home much earlier. Without a mortgage, most people would have to wait years and years and years to get into a home. And of course, renting is not a good long-term solution financially. So, we’ll treat mortgage debt differently. It’s a separate category and a separate discussion. Today we’re talking about everything else with regard to debt. This could be credit cards, student loans, personal loans from a bank, lines of credit, personal loans from family, anything like that–any money you owe to anybody.
Today we’re going to focus on avoiding three areas of debt traps that people have gotten themselves stuck in. Once stuck, it just makes it so much harder to get out.
Debt trap number one is the trap of consolidation debt. This is very tempting because there are a lot of consolidation loans out there being offered. There are whole companies built around this concept: to consolidate debt. The appeal is, “Hey, we’ll get it all together. We’ll simplify it because you’ve got all these different debts. We’ll put it all into one payment and you’ll pay it off faster.” The reality is different. Studies have been done on this and the reality is, people don’t necessarily pay it off faster because they end up going back to a lot of the bad habits that may have led them to accumulate credit card debt, personal loans, and all the other stuff. Studies show that on average, somebody who does debt consolidation actually ends up borrowing more money.
Debt trap number two is the trap of focusing on the payment. It’s very tempting to focus on the payment. People are tempted by the bank or the auto dealership or the RV company or whoever it is saying, “Well, you can afford this payment. You know, we’ll pre-qualify you and look at your income.” And they’re letting you borrow more money than is probably responsible. Then people wonder why they’re so strapped for money once those payments actually start up.
All kinds of fun stuff can be bought. We could buy jet skis and boats, RV’s and cars and all kinds of things, but just because we can afford the payment according to the bank or the finance company doesn’t mean that we should actually do that. It really ends up being a monkey on our back over time. So don’t focus on whether you can afford the payment, and certainly don’t focus on the payment somebody else says you can afford.
Debt trap number three is the trap of focusing on the interest rate. Sometimes people will borrow money that they don’t need to borrow, simply because the interest rate is low or even zero percent in some cases. They might be able to easily pay for it out of their cash flow but they get caught by the allure of a low interest rate or even a zero percent interest rate. I think this is a trap because really, when you’re borrowing money, it’s going to be a debit on your balance sheet. And I know this sounds like a math problem, but it really isn’t. This is about accumulating something that could end up becoming a problem over time. It’s now a cash flow issue, because now you have an obligation to make a payment each month. If something bad were to happen down the road where something ends up using up your savings or other money that you could have used to pay that off, you’re still stuck with that payment. It’s a cash flow issue, and it’s also a peace of mind issue.
The other end of debt besides taking it on, is paying it off. The debt snowball technique, which we’ve covered under a separate episode, is about paying off your smallest debt first and then getting to the bigger ones. Oftentimes, it’s very tempting to look at the highest interest rate debt and try to pay that off first, because we think, “Well, this is a math problem, right?” And it makes sense to pay off the highest interest first. But the reason the debt snowball works is because you’re paying off an entire debt much faster—and then you’re freeing up cash flow.
When it comes to financial planning, it all comes down to cash flow and income. Whether on the debt side or the wealth accumulation side, we need to ask why we are doing any of this. It’s about being able to have a quality of life that we want, and to have work be optional at some point, hopefully as soon as possible. That’s our goal for our clients, to get them to the point where they’re financially free as soon as possible. We have a lot of clients that continue to work well after the point that they are financially free, but that just means that work is by choice at that point.
So don’t get thinking that you have to pay off the interest rate that’s highest first, even when it’s a much larger debt and it could take you much longer to pay that one off. This is really about knocking the smallest debt out first, getting rid of each one as quickly as possible, and then taking that freed up cash flow to pile on or snowball onto the next debt.
Again, be mindful of these three debt traps.
Number one, consolidation. Consolidation typically does not work well. The odds are not in your favor to end up being a good outcome for you. It’s better to just buckle down, make your list of debts and start knocking out the smallest one first.
Number two is the trap of focusing on the payment and getting stuck in that fantasy of “Oh well, I can afford the payment because the banker or the finance company said that I could or that they would qualify me up to a certain amount.” That also can lead to people overspending. Maybe you do need a new vehicle and you go to the car dealership and they say, “You can afford this much more expensive vehicle,” or you go to the RV company and you can get the much larger RV package or whatever it is. And even when it comes to house shopping—these days in most parts of the country, houses have gotten much more expensive—but if the interest rates are very low, the mortgage company is going to say, “Oh, you can afford a payment up to X amount,” which might be way more house than what you were planning on buying in the first place.
The third debt trap is to focus on the interest rate and think, “Hey, I should borrow money just because it’s so cheap.” You’ll be much better off just paying it off as fast as possible. Don’t borrow money in the first place except for the mortgage.
Avoid these three debt traps and you will be out of it as soon as possible. The younger that you are and the earlier on in life that you are when you have these lessons, the better. So please pass this on to other people you know that might be starting out. The younger you are, the better off you’ll be, because you won’t have to dig out of the hole. You won’t have to free yourself from the trap of being in debt. It just feels a lot better. I think it’s good for your financial soul in a lot of ways. You just sleep better at night. I know that from myself and from having thousands of conversations with people that have gotten their stuff paid off. It just feels good to have no debt.
So with that in mind, I hope this was helpful. Please pass this on to anybody who might find it helpful. That could be somebody who’s just starting out or somebody who’s much further along down the path. This is about learning from each other and learning from wisdom. We’re seeking after wisdom, simply because that’s the wisest thing that we can do. King Solomon actually wrote that in the Book of Proverbs. He said that seeking wisdom is the wisest thing you can do. That’s what we’re doing here on the Wiser Financial Advisor.
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I hope you have a great week and God bless.
The opinions voiced in this episode of the Wiser Financial Advisor with host Josh Nelson are for general information only and not intended to provide specific advice or recommendations for any individual. Investment advisory services offered through Keystone Financial Services, an SEC Registered Investment Advisor.