Stupid Debt, Smart Debt

The rich are different. And they think about debt differently. Most people struggling with overwhelming debt dream about being debt-free. Yet many wealthy individuals willing get in and out of debt all of the time. In fact, debt is part of their overall financial strategy.

 How does that work?

It’s smart debt. Smart debt is using debt to leverage money. For example, if I can borrow money at 6% but can make 10% investing it, it’s smart to borrow in order to invest. Granted, such situations are incredibly rare in actual real life, but it’s a theoretical answer.

Smart debt is always about improving your bottom line, that is, your individual net worth. For example, let’s say I shop around and find a very underpriced home on the market for $100,000. I buy it, putting $10,000 down and taking out a $90,000 mortgage. If the house could truly be resold for more money, that’s smart debt. Let’s say I invest another $10,000 to spruce the place up. Now I’m in the hole $110,000. But if I can turn around and sell the place for $150,000, I just made $40,000. That’s using debt the way the rich do.

But if I really really really want to go to DisneyWorld and don’t have the money and load up my credit card for $10,000, that’s not improving your net worth. You may have memories, but you’re out $10,000 and there’s no hope to recover that (you can pay it off, but you can’t turn around and “resell” your vacation). Not only that, you owe interest which is rent on your money.

Smart debt is characterized by three things:

1. There is an exit strategy. You don’t get into smart debt unless you know how you’re going to get out, when you’re going to get out, and what your emergency exit plan is in case disaster strikes.

2. You are leveraging or amplifying the power of your money, that is, you are using the debt to “buy an opportunity” that won’t otherwise be available to you or would not be wise. For instance, if I buy a house with a mortgage, thinking I can re-sell, it might not be smart for me to liquidate my 401(k) plan to make the purchase … but a mortgage would work.

3. The smart debt improves your net worth.

Debt Consolidation Calculator

Just found this cool resource. It’s basically just a debt calculator, but it can work great to see if debt consolidation is a good solution. It’s at http://moneycentral.msn.com/investor/calcs/n_debt/main.asp.

Debt consolidation is not a magic solution; it doesn’t work for everybody. In fact, it probably won’t work for the majority of people with big debt. But it does work for some and if it’s the right solution, it works better than just about anything else.

 This calculator can help you see what kind of results you might get if you gathered all your debts together and paid them off at a particular interest rate. The lower the interest rate, the better. But you won’t qualify for low interest rates unless you have pretty decent credit.

King Solomon

King Solomon was one of the richest men who ever lived, and he wrote a lot about money. It’s in the Bible, in the book of Proverbs. Solomon actually addresses a lot of topics, but money is right up there. Some of his advice:

1. Don’t co-sign a loan. (He says this repeatedly!)

2. Hard work and money go together. That doesn’t mean that all rich people work hard or that everyone who works hard will get ahead. But he noted a correlation. You just improve your odds of having money if you’re willing to put in the work.

3. It’s more important to seek wisdom than money. He didn’t say to ignore money, but his writings imply that if you seek wisdom, you will be able to get money.

 Pretty relevant stuff. So many people pursue money without really understanding how it works.

Prosper.com

There’s this website I just heard about called Prosper.com. I have not had much opportunity to study it, but it looks sort of like an E-bay but for lenders. The idea is that if you want a relatively small (< $25,000) unsecured loan, you can go to other people to borrow the money rather than banks.

A lot of financial institutions don’t like this sort of lending to begin with. For the borrowers, the big draw is that you can borrow money (the posts I saw had attracted lots of “bidders” seeking to lend people money) without the hassle of going to a bank, which probably didn’t want your business to begin with.

I’m not sure what the upside is for the lenders. True, they could be getting a pretty good return on their investment–some of the interest rates I saw quoted were in the high teens and even 20%. But there has got to be a risk.

I’m going to look into this further.

What Debt Consolidation Is and Is Not

Debt consolidation sounds like one of those things that you sort of understand. But when you really ask people about debt consolidation, sometimes they get it mixed up with debt relief or bankruptcy or other financial plans to deal with excessive indebtedness.

Debt consolidation is actually a debt. It involves rolling together (consolidating) your smaller debts into one large debt.

For instance, let’s say you owe $20,000 on six different credit cards, plus you have $12,000 more to pay on two car notes. The debt consolidatiuon approach would take out a loan of $32,000 to pay those debts off. So far, so good. (That’s why debt consolidation can, in some cases and used properly, actually improve your credit rating.)

The problem is that now you have one giant debt of $32,000. In a way, you didn’t really gain anything, you just re-structured your debt.

But the re-structuring can be a smart financial move. If you do it correctly, you can often get a lower interest rate on the large debt than you previously had on your string of smaller debts. This is particularly true if you had a lot of in-store loans (for electronics, furniture) or department store credit cards. This means your monthly payment on the $32,000 should be lower than the sum of your smaller payments.

The single payment is also simpler. You’re much less likely to get hit with late fees or wind up robbing Peter to pay Paul as you juggle minimums on many different loans. In the world of finance, simpler is often better.

Debt settlement, debt relief, and debt negotiation are plans that involve going to your creditors and trying to negotiate a lower payment of some sort. These approaches have their merits in some situations, but they almost always hurt your credit score and they can be risky. Check out debt conslidation first; these other plans should be more like backup in case you can’t make debt consolidation work for you.

Bankruptcy is a last resort. That’s not to say it doesn’t have its place, and there are people who need to use it. But bankruptcy not only messes up your credit (for seven years), it takes away a lot of your financial freedom, not to mention decreases your financial self-confidence.

Debt consolidation is a very moderate approach. In fact, many businesses restructure loans all of the time since it’s just financial common sense in some situations.