Tip Number One:
Households need to limit the amount of their debt they pay over their lifetime even if this goal requires them to delay home purchases and 401(k) contributions.
For many households, financial planning involves around two goals — (1) purchase a home and (2) save for retirement. The advice they receive in this process from their realtor and their retirement advisor is unambiguous.
The realtor almost always tells the potential homebuyer that house prices are going up. The realtor with the loan officer generally advises the use of a 30-year mortgage over a 15-year mortgage because often the use of a 15-year mortgage would require that the person purchase a smaller home or wait until they have a larger down payment.
Financial advisors stress the importance of placing money in a 401(k) plan. The financial advisor generally recommends that people start placing money in their 401(k) plan as soon as they start their career and always take the full employer match. Often the financial advisor will recommend that you make the fully allowable contribution to your 401(k).
People who follow the financial game plan of buying a home and contributing to their 401(k) plan right after college instead of paying off debt are likely to fall in a debt trap where they work for the bank their entire life.
Consider a person finishes school with $80,000 in student loans and $20,000 in credit cards. He makes home purchases and 401(k) contributions a priority over debt reductions. After taking out the student loan and the credit cards he continues consuming and borrowing often on less than favorable terms. Over the course of his lifetime he buys three homes with 30 years mortgages and five cars all on credit. The loan history for a hypothetical person is presented below.
|Lifetime Loans for a Hypothetical Borrower|
|Debt Type||Amount||Interest Rate||Maturity of Loan in Months||Years Loan Held|
|Car Loan 1||$5,000||7.00%||60||60|
|Car Loan 2||$10,000||7.00%||60||60|
|Car Loan 3||$15,000||7.00%||60||60|
|Car Loan 4||$20,000||7.00%||60||60|
|Car Loan 5||$20,000||7.00%||60||60|
How much does this person pay in interest over his lifetime?
|Lifetime Interest for the Hypothetical Borrower|
|Debt Type||Cumulative Interest over the life of the loan|
|Car Loan 1||-$906|
|Car Loan 2||-$1,812|
|Car Loan 3||-$2,718|
|Car Loan 4||-$3,624|
|Car Loan 5||-$3,624|
This is not an atypical situation. Paying over $600,000 to banks in the form of interest over the course of a lifetime is plain CRAZY! The household who pays over $600,000 to the bank in a lifetime is essentially a slave.
In order to avoid this debt trap people must pay off credit card debt ASAP, accelerate payments on their student loans and take out a 15-year FRM rather than a 30-year FRM. This can only be accomplished by delaying home purchases and by reducing investments in financial assets. For most households, the debt reduction strategy will necessitate some reduction in 401(k) contributions.
People need to reduce the amount of debt they pay banks over the course of their lifetime. The can do this by getting rid of credit card debt as quickly as possible, accelerating payments on their student loans, delaying purchase of homes, and using a 15-year FRM rather than a 30-year FRM.
This is heresy for many financial advisors who stress always taking full advantage of employer matching contributions. Most likely these financial advisors were never in a situation with poor job prospects, low liquidity and spiraling debt.
The situation presented here is not a worse case scenario. Many households fail to quickly reduce their credit card debt will have their credit rating deteriorate. A poor credit rating will impact job prospects, insurance costs, and even the ability to rent an apartment.
My first tip is a general one. People need to make debt containment a priority over other financial goals including home purchases and contributions to 401(k) plans.