The novel, “Little Dorritt” by Charles Dickens features a debtors’ prison as a key plot device. The author’s own father was imprisoned in the same prison described in the book. Debtors’ prisons have existed for centuries. The slang term “clink”, meaning prison is derived from a debtors’ prison in England, The Clink. Sentencing terms were open-ended. A prisoner would be released upon payment of the debt. It was not rare for debtors to spend decades behind bars.
They were only outlawed in the United States in 1833, but existed in England into the 1860’s. Remarkably, there are several states that still allow for imprisonment for failing to pay a debt. Most of these are related to failure to pay child support. The idea of debt being “bad” is closely associated with the historic experience of being jailed for not repaying it. Even today, the idea of debt is cloaked in negative terms.
Rather than thinking about debt in emotional words, investors should classify debt into two types: constructive debt and destructive debt. The most well known of constructive debt are home loans.
Even if you have enough cash to avoid a loan, it may make sense to take out a loan and invest the cash in the market. The question to ask is whether you think you can get a better return investing in the market than the rate you are paying for the loan? If you can get a 6% return in the market and a 3% loan on the house, it does not make sense to pay cash. Of course, you also have to consider other fees like origination, appraisal fees, etc. to determine the full amount of the loan.
A mortgage can be an effective means of creating future wealth. Most houses in decent neighborhoods increase in value over the long haul. In many cases, the home value may be the single largest asset in someone’s portfolio. Don’t be house rich and cash poor. The size of the loan should be commensurate with your income and ability to pay. Only the investor can make that decision. The most common rule of thumb is that you should not pay more than 30% of your monthly gross income on housing. A person with no other debt maybe to go a bit higher.
Also, it is important that the homebuyer knows the terms of the loan. Is it a fixed or variable rate? How long is the loan? 15 years? 30 years? Are there penalties for early re-payment?
Carrying a monthly balance on a credit card is destructive debt. You are paying a high interest rate and merely treading water. The slightest financial emergency could cause you to miss payments. This debt spiral will take years to recover from. It is overly simplistic, but no one should make a purchase on a credit card that they cannot pay the balance off in the next billing cycle.
Oftentimes, someone who has been caught in this modern debtors’ prison will juggle balances across multiple cards. This disastrous behavior is a financial nightmare. There are a couple of approaches to solving the problem of credit card balances. One method would be to select the card with the highest interest rate and begin sending additional money monthly until it is paid off. Then move onto the next highest rate card until all debt is eliminated.
The second method is more a financial behavior approach. Select the card with the lowest balance to send additional payments. This card will be paid off more swiftly giving the cardholder a sense of accomplishment. Regardless of which method is used, all credit cards should be stuffed in a drawer and not used again.
Once someone gets a handle on this destructive debt, they should pivot to creating an emergency fund of 3 to 6 months of expenses. The time frame is dependent on your family situation, work security, and overall budget. Knowing you have this reserve of cash will bring a sense of calm after overcoming the monthly credit card bill nightmare.
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