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I know I said I was going to start a series on how to build up a money reserve, but I figured it might be important to first discuss how to stay out of debt. The last thing you want once you are free from debt is to end up shackled right to it again. So here's a little crash course on staying out of debt.
- Good and Bad Debt. There are two kinds of debt: good and bad. Good debt would be classified as mainly things such as a mortgage, student loans, and if necessary car loans. Bad debt is credit cards, store cards, personal loans, etc. The main difference between the two is that with good debt you gain something with long term value and with bad debt you generally gain something for short term happiness. A good way to know if something is worth the debt you will incur is to figure out how much it will cost when the interest over time. For example, you are probably willing to pay the interest on a home loan because you will have a place to live and you have an asset in home. You probably think the interest on a student loan is worth it because it allows you to gain education and hopefully increase your earning power. You probably won't be willing to pay interest on a candy bar or a movie.
- Whenever you can, pay for something outright. This applies to "good" debt and big ticket items. You should always pay for regular purchases in full. If you have enough money saved, and a good reserve it is better to pay for things in full. Cars are a prime example of this. Cars depreciate the moment you drive off the lot, so it can become very easy to become upside down in a car loan. It would be better to buy a used car that you can pay in full for than to buy a brand new car that you end up with a large loan for. At the very least make a large down payment and opt for shorter terms. The same is true when you want to remodel your home or buy a big ticket item. Financing may seem like a good idea, but inevitably you will pay double the amount it cost in interest, and you generally will not make that much in interest if it stays in your bank account and you may not make back the amount of money you put into (with interest) it if you sell it. There are reasons why one would choose a loan over paying in full, but they need to be carefully selected, usually after consultation with a financial expert.
- Using a Credit Card Properly. Believe or not there is a correct way to use a credit card. The correct way is to pay off your balance in full before you have to pay interest. You shouldn't buy anything that you can't pay for from your bank account right then. You need to still stick to your budget. There are many advantages to using credit wisely. Your credit score will increase. You may also acquire some sort of points for a reward program. For example, my husband and I have a credit card that offers 1% of every purchase as payment to our mortgage. Used wisely this can be a great benefit as it will help to pay down our mortgage faster just from making our regular purchases. Used unwisely and we end up losing all the benefit in interest payments.
- If you can't control yourself, don't use it. If you know that the moment credit cards are in your hand you will use them, then don't. I would recommend a cash system where you can't spend more than you have budgeted for the month. I wouldn't even use debit/check cards. Once you can live by a budget, you may be able to then slowly work toward using a credit card in the right way. Until then it would be better to just do without.
- Have a financial reserve! Most people end up back in debt because they fall on hard times or end up having to pay a large amount of money for an unforeseen event (air conditioner breaks, car breaks down, medical bills, etc.). I will begin a series on this next week.
Do you have any tips or tricks your family uses to stay out of debt? I'd love to hear them! Please comment below!