False Hopes And Credit

By Felipe


Since I wasn’t born or brought up in the US, I’ve noticed that my perspective on personal finance is a bit different than the avererage American. Coming from a hard-working middle-class family from Brazil, I lived part of my life under hyperinflation and economic turmoil, and because of that I do have some insights on how to manage personal finances.

6 years ago, I had just moved to the US and got a credit card. I had the habit of using credit cards in Brazil too, but they are not as prevalent as here in the US. Full of excitement, I brought up the subject in an informal conversation at my workplace (you know, that was my very first foreign credit card!). That’s when a co-worker came up as excited as I was, telling us that she was so happy because she just finished paying off her debt. At the time I did not quite understand what she meant, but later I talked to a friend who broke me the shocking news: Most people actually use credit cards for (well) credit!

Back in Brazil at the time (now things have changed), we normally used credit cards simply because of the convenience of not carrying cash and also for getting an itemized list of expenses at the end of the month for free. Paying off the credit card in full every month was simply a fact of life — I don’t even recall seeing minimum payments in the statement. In a country with interest rates between 40% and 80%, people are obviously not too crazy about accumulating debt.

Having said that, I am not implying that credit in general is evil. On the contrary, credit is a wonderful tool for economic development: Student loans make higher education accessible to millions of Americans, and microcredit is doing miracles in developing countries. What I am saying is that credit must be used responsibly. And here is the rule I follow:

Use credit only to buy stuff that will pay itself off in the long-term.

Reasonable (low-interest / low-fees) student loans are good, because in the long-term education will allow you to get better paying jobs. A reasonable mortgage in an affordable area is ok if you are there for the long-run (I’m not talking about voodoo-loans and over-valued areas!). Car loans are bad because the value of the car depreciates over time. Credit card debt is bad because all the stuff we can buy with a credit card does not increase in value. In fact, if you follow this rule you will find out that credit in general is good only for very few events during your lifetime.

I think people get in trouble with debt because there is always an optimism that they will land a better job or make more money in the future. However, in reality that does not make any sense, because even the most optimistic scenario will not keep up with the debt! If you make $60,000 and have $5,000 debt at 10% APR, you are unconsciously expecting a 3% real increase in your salary every year, so you can pay off your debt over 5 years (I posted my rationale for that calculation as a comment). A 3% increase per year may not sound like much, but how many times do most people actually get consecutive raises these days?

Beyond the (tangible) optimism of a better future is the (false) hope that things will go smoothly over a long period of time. In a 5 year period, someone will lose a job, or get sick, or have to repair the car… Because of these unpredictable events, an emergency savings is very important. If you have a cushion, you do not need to tap into other assets like your house or retirement savings to take care of these emergencies.

But for me, the most serious consequence of bad debt is that it increases your liability for everything else that follows in your life. You might be forced to keep a job you just hate, or pass up a great long-term opportunity because it does not pay enough in the short-term, or work more hours (and spend less family time) to pay off the interests, or postpone that dream trip, or not be able to go back to school…

“But what madness must it be to run in debt for these superfluities! .. . Think what you do when you run in debt; you give to another power over your liberty.”
— Benjamin Franklin, from Poor Richard’s Almanac


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