Keep Your Hands Off of My Stack

Debt sucks. It's also often unavoidable. Reconciling these two facts is tricky, and I can't claim to have all the answers, but I'll do my best in this session.

So, a recap: debt is when someone lends you money, and you need to pay them back later. This almost always is accompanied by interest, the money you pay for the privilege of having early access to money. The more time you take to pay off the debt, the more interest accumulates. If you fail to repay a debt, catastrophic consequences can ensue.

There can be good reason to go into debt. Almost nobody has enough money in their checking account to buy a house, and it can take decades to save it up, so it can make sense to take out a loan to buy your home. Importantly, you're borrowing money to buy an asset: something real, which has value, and may become more valuable over the long term. You can also take out a loan to buy a vacation to Rio - this may be a lot of fun, but when it's over, all you'll have are the memories.

Here are some different types of debt you will likely encounter, and how to handle each one.

CREDIT CARDS

When it comes to sheer number of transactions, you will do far more with credit cards than any other type of debt. They are a huge convenience in today's world - the only option for most online purchases, a handy alternative to carrying cash and checks.

How to get one: You're probably inundated with offers in the mail. (Tip: you can opt out of these mailings. I've done this, and cut my junk mail in half.) Some of these may be good, but many will be bad - read the fine print carefully. You can also shop around online - try bankrate.com, or go directly to a bank's web site. Finally, you may also be able to get one through your regular bank. The bank will run a credit check on you - basically, see whether you have a history of paying your debts. If your credit score is low, you may get poor terms or altogether refused.

How to pick one: Every offer letter should contain a box that shows the interest rates, fees, etc. First of all, ignore any with an annual fee. Next, consider the interest rate. If you're going to pay the card off in full every month, this can be relatively high; if you're going to carry a balance, you want something low. Finally, consider rewards. I've been happy with Capital One's No Hassle Cash Rewards, which gives a simple 1% rebate for all my purchases. Other cards may offer higher but more restricted rewards (for example, 5% rebate, but can only be used to buy a car from GM). Rewards cards usually have an annual fee or higher interest rate, so only consider them after you've paid off any credit card debt. Oh, and be sure to pick a card with a grace period (at least 14 days, longer is better.) This will let you avoid paying interest as long as you're making full payments. Once you get your card, sign up for an online account, and get ready to pay it off with your checking account.

How to use it: Use throughout the month. If you have a rewards card, you should generally use it even when you could pay cash - AS LONG AS YOU ARE ONLY BUYING THINGS YOU WOULD ANYWAYS. You should pay off your credit card in full every month. If that isn't possible, pay off as much as you can. You'll be paying interest on new purchases, but should be closing the gap. You might want to occasionally log onto your credit card web site to see how big your next statement is going to be. You'll generally have about 2-3 weeks after receiving your statement to pay it off. Either set yourself a reminder, or (my preference) pay it off immediately. Just one missed payment can cause you to lose your special terms, increase your interest rate, etc. If you pay through the mail, give plenty of time for them to receive and process the check. If you pay online (which you should!), note that it can still take 5 business days or so to process a payment - their web site should say exactly how long. Give yourself plenty of time.

Advantages of credit cards:

• Convenience - it's less to carry around, quick and easy to use.
• One nice perk of a credit card is that, as long as you pay it off in full each month, you don't need to pay any interest at all. In other words, even if your card has a 15% interest rate, if you buy something for $100 on the 1st, receive your statement on the 20th, and pay it on the 30th, you still only owe $100.
• Credit cards come with protection against theft: if someone steals your cash, it's gone; but if they steal your credit card, you're only liable for the first $50 of purchases, and your bank might waive even that.
• Some credit cards come with minor miscellaneous perks, like free travel insurance, automatic warranties, etc.

Disadvantages of credit cards:

• Convenience - it becomes very easy to spend money without thinking much about it. For many people, credit cards don't feel like "real" money, so they spend more.
• "Gotcha" clauses - especially in recent years, many contracts are set up so that if you fall behind in payments (even on another card), your interest rate will go up.
• Banks can also change their contract at any time, although they must notify you and give you an opportunity to cancel your account.
  
• Usurious rates: it isn't unusual for a "default rate" card to charge over 30%.

Other alternatives: A bank debit card is available to everyone with a checking account, even if you have lousy credit; the debit card can generally be used wherever a credit card can, so it is useful for online purchases, certain vending machines, etc. Note that you cannot spend more than is in your account, and that you do not get the same protections that you do with a credit card. (For example, if someone steals your debit card, you are theoretically liable for all charges, although in practice banks will often waive this.)

STUDENT LOANS

You'll probably keep this debt longer than any other, besides your house. Most of us don't have a ton of money when we graduate high school, so we take these loans to close the gap between what we have and what we need for college. Unlike credit cards, this type of loan is an investment - you are buying a better future and probably higher earning potential.

How to get one: Your school's financial aid office will probably provide you with a package of loans. You (and your parents) will need to fill out FAFSA in advance so they know how much you are eligible for. You can also take out loans from private lenders - again, bankrate.com is a good resource - although you probably won't get great rates. Note that there are two major classes of loans: "Subsidized" and "Unsubsidized". Subsidized loans are generally from the government, and have a very low interest rate, lower than anything you can find on the market. Unsubsidized come from everywhere else, and have a more conventional interest rate.

How to use it: Very little effort will be required other than your signature; money goes directly from the lender to the school. You are not required to make any payments while you are a student, even though the loans accumulate. After graduation, you will have a short grace period, after which time you will need to start making payments. You will get new loans for every year you borrow. You will have the option to "consolidate" your loans, which means combining a collection of smaller loans into one big loan. Usually this will also provide you with a fixed interest rate rather than one that changes every year. Read the fine print to see whether this is a good deal for you - if rates are very low, like they are now, then it's probably a good idea. Once you begin making payments, treat it like any other debt. Pay the minimum on everything, and put as much as you can towards the highest-interest rate loans. Note that, if you're lucky, your subsidized loans might have an interest rate that is even cheaper than the interest you earn in your online savings account. In this case, even after you have paid off the rest of your debt, it makes sense to continue just paying the minimum on these loans - as long as you save the money in that account instead of spend it! Sign up for automatic bill payment, since your loan repayment will be a consistent charge every month.

Advantages of student loans:

• They generally offer lower interest rates then you'll find on credit cards.
• They're one of the few sources of enough money for today's really high education costs... Wash U will be charging over $50,000 next year, which you couldn't put on your credit card even if you wanted to.
• They offer flexible repayment plans.

Disadvantages of student loans: It's easy to forget about them while you're in school, and they can really surprise you after you leave.

Alternatives to student loans: Grants, fellowships, and scholarships are always better than loans. Do consider cost when you're looking at colleges - a more expensive school doesn't necessarily mean a better experience. If you're already earning a decent living, consider saving up in advance for tuition, or working to put yourself through school (possibly part-time) in order to avoid debt.

CAR LOANS

This really stands in for a class of similar loans where you borrow a large sum of money to make a single purchase. Many of us require a car in order to get to work and necessary stores, and also enjoy using a car to visit friends or go on trips.

How to get one: Dealers are very eager to lend you money. Many companies, like GM, actually make more money charging interest on cars than they do on selling them. You can also borrow money from your bank, or any other bank; this is the only option if you're buying from another individual instead of through a dealer. To decide who to borrow from, look at who offers the lowest interest rate. If the dealership offers a choice between "cash back" and a low interest rate, use math to figure out what is the best deal. After you decide, they'll run a credit check on you, so don't get too attached to a car until you know that you've cleared it. Decide what repayment schedule you want - longer periods usually mean lower payments every month, but more total money spent in interest. You should pick the shortest payment schedule that you can comfortably afford.

How to use it: If financing through the dealer, they'll handle everything, and you'll just sign papers. If through a bank, they'll give you a check from the bank that you'll fill out after you agree on a purchase price. In either case, you'll start making monthly payments almost immediately. Sign up for automatic bill payment, since this will be a consistent charge every month. Laws vary by state, but generally, you will need to give your car's title to the lender, and won't get it back until the loan is complete. The lender actually owns the car.

Advantages:

• This may be the only option for getting a car if you need one and don't have the money.
• Unlike credit cards, the term is fixed, so you know exactly how much you will owe every month.
• In certain circumstances you can get very cheap interest rates that are lower than the market average.

Disadvantages:

• You're borrowing money to buy an asset that is depreciating over time; it's possible that at some times you will owe more on the loan than the car is currently worth.
• This type of loan is what is known as "secured": if you fall behind on your payments, the bank has the legal right to take back the car, and will do so. (By contrast, if you fall behind on your credit card payments, your credit score will suffer and you may be sued, but people won't take stuff from you.)

Other alternatives:

• Buy a cheaper car! In retrospect, I wish I had bought a used car instead of a new one after I graduated from school; I would have still needed a loan, but it would have been smaller.
• If you can, seriously consider saving up to pay for the car with cash. You'll save a lot of hassle, and may save on interest as well.
• Best of all, forego the car altogether. If you're lucky enough to live in a city, you can probably get along just fine with walking and public transit, potentially supplemented by a bicycle. You'll save a lot of money, get good exercise, and let someone else do the driving while you read, listen to music, or write blog posts.
  

MORTGAGE

I'm stepping more on a limb here - I've never had this type of loan. Still, I'm aspiring to become a debtor, and so have been doing a lot of reading on it.

How to get one: You can find a mortgage through your bank, or any other bank; it is very common to use someone else for mortgages. Look at bankrate.com for cheap rates. If you are buying new construction, the builder might strongly encourage you to use their lender. There's a bit of a dance involved; you won't know how much a house will cost until you negotiate with a seller, but you don't want to start negotiating unless you're certain of what you can afford; additionally, sellers will want to know that you've already been approved before they take their home off the market. So you'll need to determine an upper ballpark of what you can afford, apply for approval, get a letter saying that you're good for it, and then after you find the house, apply for the actual loan. There are many other options involved, such as the duration of the loan, whether it is fixed or variable interest, and whether you will pay "points" to decrease the interest rate. These factors deserve their own blog post, which probably won't go up until after I've actually done it.

How to use it: The bank will send a representative to closing, and you will sign an enormous number of papers. The situation will vary depending on the lender and the state you live in, but generally, you will make a regular monthly payment to the bank, which may also include prepayments for property taxes and insurance.

Advantages:

• Even for wealthy Americans, this is the only option if you are going to buy a home.
• You can deduct the interest and some other expenses on your income taxes, potentially saving a lot of money.
• Homes are generally (not always) appreciating assets: you're spending money that you would be paying on rent anyways, and will eventually own something more valuable than when you first got it.

Disadvantages: Like car loans, the mortgage is a secured loan: if you fall behind on your payments, the bank can kick you out and take possession of the home. The many options for mortgages can be confusing. If you get a variable interest rate (ARM) loan, it's hard to plan how much it will cost in the future.

Other alternatives: Rent. Take a serious look at how much you would pay every month on your mortgage, and all the other expenses (down payment, taxes, insurance, homeowners association fees). You might be better off saving or investing the extra money rather than paying it on interest for your house. Don't take a mortgage that will suck up all your funds - what's the good of having a house if you spend all your time and go broke trying to keep it? Consider how expensive renting is in your city versus housing. Look at how expensive home prices are compared to the median income. If housing looks very expensive in those regards, compared to the rest of the country, then housing might be over-valued, and perhaps you're better off renting for now.

There... between credit cards, student loans, car loans, and mortgages, I think I've (briefly!) covered the debts that most of us will encounter. If I've left out anything major, please remind me in a comment.

In general, then: debt is a reality of life for most of us, and with some advance planning, you can keep it under control. Try to keep your debts low, so you can spend your interest on your own dreams instead of your lender's.

After your high-interest debts are paid off, and the remaining ones are under control, you'll be ready to move on to the next stage of your financial foundation: investment. You don't need to be a wizard or know all the obscure funds out there - in fact, you're better off if you don't. Just use a few well-tested and well-understood investments, which we'll start looking at in our next session.