Taking on a staggering amount of debt without ever really considering how you’ll afford it and what that means for your future seems to have become somewhat of a norm in America. This is troubling to me, and I think it’s important to realize there’s another way.
Mrs. Wallet and I both recently graduated from college, and neither of us felt any need or desire to take on any debt at any point in the process. Most notably, Mrs. Wallet had been paying for her schooling on her own prior to ever meeting me. The reason I highlight this is that I make a lot more money than she does, and she doesn’t get her jollies modeling things in Excel or Google Sheets or planning and managing all things money, the way I do.
In fact, Mrs. Wallet doesn’t even like checking account balances and generally tries to spend as little time concerned with money as possible. At the end of the day, the point of this blog is to help you spend as little time worried about money as possible as well. By doing a bit of upfront work and setting up a system that mostly manages itself, you can actually end up spending much less time on money by avoiding its pitfalls and enjoying its perks, leaving more time for actually living your life.
Avoiding debt
You have probably gotten the picture by now that I’m not a huge fan of debt. For the most part, it’s true that I think you should avoid debt at all costs, especially if you’ve had problems with it in the past or are just starting out on your financial journey. That’s not to say that debt should never even be considered, but rather that most never stop to truly consider it and what it means for them.
Debt can be good in some circumstances. It’s not that debt is evil, a priori; it’s just a tool like anything else, devoid of meaning (positive or negative) outside its context. For example, even if you can afford to purchase a vehicle with cash, if you can get a 0% interest rate, it may make sense to finance it, as long as you are making a reasonable decision about the car (aka it’s used) and have financial discipline*. If you would actually be investing that money instead, you’ll end up way ahead. If buying a house makes sense for you, debt may be an excellent instrument for achieving that goal, especially if interest rates are at historical lows.
By contrast, if your proposed debt is at a high interest rate, it’s probably a bad idea. If you’re just entering college and considering taking out loans, particularly if you’re working toward a degree that won’t land you much of a salary increase, you may want to reconsider whether a loan is the right tool for you.
Life isn’t so simple that there’s a cookie cutter solution for every situation: “if you encounter X then do Y” and so on. The point I’m repeatedly making is simply that you should understand the decisions you’re making and their impacts on you and others prior to making them. Then, if you still think it’s a good idea, go for it! Failure and setbacks are two of life’s greatest teachers, and I’ve learned a lot from them. That’s the real reason I’m writing: to help you avoid the traps I fell into and take advantage of what I’ve learned as a result.
As a simple example, assuming you have stellar credit, the average car loan can leave you paying 20-30% or more over the cost of the car in interest as well as doubling the amount of time you’re stuck paying this expense. And anyone who has ever looked at a home loan amortization table probably wasn’t filled with warm fuzzy feelings.
Credit cards
One form of debt that has sparked much controversy and can mean very different things for you depending on your discipline and proclivity for spending is a credit card. Credit cards are either one of the best or one of the worst forms of debt, depending on how you use them. This is one area where my philosophy departs from YNAB’s.
Used responsibly, credit cards effectively serve as an interest free loan for up to roughly 50-60 days, in addition to potentially netting you a hefty return in the form of either cash back or free flights and hotel stays. If you leverage techniques like manufactured spending or travel hacking, they can be helpful tools, enabling you to afford traveling like a king without hurting your pocketbook.
However, this is dependent on you paying off the balance in full each month. If you don’t pay off the full balance each month, the interest rate is enormous. This should naturally be avoided at all costs; if you’re not disciplined enough to pay off the full balance each month, treating your credit card like cash, avoid credit cards like the plague until the frugality muscles in your brain have grown to the proper proportions.
How to save for anything
The usual model looks something like this: Spend all of your money (and then some). Don’t plan or save for purchases you know will eventually come. Use debt to finance said purchases, paying far more than the value of what you’re buying or what you can actually afford over a much longer period.
Let’s turn this on its head! What if instead of going through all that, we shortened the process and saved ahead of time, paying ourselves and collecting interest instead of paying it, ultimately allowing us to pay cash for what we want or need, if we still want or need it at that point? Sounds a lot less stressful, doesn’t it?
What would this actually look like? Let’s say we think we’ll need a new car in three years, and we plan to spend $10,000 after selling our car. Taking the total and dividing by the number of months (3 years x 12 months in a year translates to 36 months), we end up with $277.78 needed per month, assuming no interest. With interest, it will take either less money or less time to get there, so we could either call $275/month good or make it $300/month, just in case.
Now, hopefully you’re giving yourself more time than this for such a purpose, but either way let’s contrast this with the usual way of doing things. In the old model, especially at the beginning, much of the payment is interest, so only part of our $300 payment actually reduces our debt, with the rest going to the bank. You have to make these payments, otherwise the bank will take your car. They are going to last much longer.
In the new model, you pay yourself 275-$300/month for a shorter period, automatically transferring the money each time you get paid into a separate account with a decent savings rate. If an emergency pops up and you need to forego contributing to this fund for a few months, nothing happens. The money quietly goes on making more money for you in the form of interest (which itself then goes on to make interest), and perhaps you catch up once the crisis has passed or simply push your car purchase back a few months. No big deal.
Let’s take a look
The above graph compares saving versus financing a $10,000 purchase, in this case a car. There’s a lot of info packed in, so let’s unpack it. First, the red and blue stacked area charts show the amount of interest and principal you’d pay over the course of a five year loan at just over 8% (the US average for 1Q2019). The average auto loan is actually around 69 months, but I couldn’t stand that level of ridiculousness. The green and orange lines show how much you would have over the same period if you saved instead.
The orange case represents saving $275/month at 2.69% interest. This is the amount we saw above we needed to save ahead of time to purchase the car in cash, at the rate of the best savings account available (barring Netspend accounts). This represents how you would save ahead of time if you needed to purchase the car in three years. With interest, you actually hit $10,000 a few months early, around month 32 or 33. So a more accurate graph might show this occurring prior to when the auto loan would start.
The green case represents saving $300/month with 7% returns. If you save in advance for the car, instead of paying the auto loan every month for five years, you could invest it instead. 7% annual returns are a conservative estimate for the stock market. What could you afford with an extra $20,000?
Looking at the loan part of the chart shows that over the course of five years we have hundreds of dollars of cashflow dedicated to paying off our loan. By the end of this loan (which is much smaller than the average and in general a very conservative example), we’ve paid an extra ~23% in interest, versus the alternative of having roughly $20,000 in the bank. Obviously, using actual average loan amounts, terms, and rates tips the scale even further in the direction of saving, especially if you don’t have stellar credit.
Graduating debt free
Planning and saving ahead of time is the exact method we used to afford Mrs. Wallet’s college degree, as well as how we plan any big, semiannual, or annual purchases and contribute to retirement accounts. Below is an example of my plan to save for one of her tuition payments. In this case, we were saving per paycheck versus per month.
Start now
Another method that can be used successfully is to start saving for a replacement as soon as you purchase something big. For example, if you just had to purchase a new laptop, you know at some point you’re going to need a new laptop.
Let’s say you spent $1,000 and got a really nice laptop. Depending on how you use your laptop, you probably have a pretty good idea that you’ll be replacing it sometime in the next 2-10 years. If we also assume you’ll spend a similar amount of money, you can use the same method described above. Simply divide $1,000 by say, sixty months (five years) and you’ll figure out you need to stash away $17 or so per month to hit your target.
This way, affording the $17/month isn’t particularly painful, and when you get to needing a new laptop you already have the money sitting there in the bank waiting. This is a much better feeling than suddenly realizing you need to shell out $1,000 and not having it.
This method isn’t for everyone, but it’s an option. I don’t personally use it, mostly because I like to keep as much cash invested in the market as possible. Our savings rate is high enough that I can simply divert some funds at the time of purchase and be fine.
Another important note for this saving tactic is that it can be confusing or require some manual tracking if you don’t have either a budgeting system (like YNAB) or bank (like Citi) that allows you to easily save for several different goals in the same account. Luckily for us, the world is busting at the seams with new fintech that is designed to make automating and systematizing savings goals like this as easy as clicking a couple buttons. Going through the details of this are a bit beyond the scope of this post, but if you want to hear more about that, let me know and I’ll write about it!
Realistic expectations
This method should enable you to afford just about any savings goal you can conjure up, within reason. If the numbers don’t add up to your expectations, you either need to adjust your expectations or make more dramatic changes in your behavior.
For example, if you want to purchase a $100 million yacht but work at McDonald’s part-time, you have two options. You can either reset your expectations, because at your current rate you’ll die before saving $100 million; make dramatic changes in your life, sacrificing whatever necessary to achieve your goal; or find a happy medium.
Shooting for the Moon
Ultimately, I believe there are more important goals than a big expensive boat, but who knows? Maybe making the changes in your life necessary to even move in the direction of affording a yacht may take you on an unexpected journey you never would have otherwise undertaken, regardless of if you end up reaching that specific goal.
This is going to sound cheesy, but “if you shoot for the moon and miss, you’ll end up in the stars.” We’re aiming to retire by 35 at the latest. If things get off track and it ends up being 36, will we cry? I don’t think so.
What are you saving for? Have you used this method in the past, or do you use a method I didn’t mention here? Share your thoughts below!
Love,
(Your) Wallet
Footnotes:
*MMM has different thoughts on this, here and here. To summarize at an extremely high level and in relevance to this post, financing can lead you to make poor decisions like buying too much car.
