Is DEBT Fueling Your Life?

In our society, having debt fueling your life is the norm because we have easy access to loans and credit. But it should be the exception. Here's why.


Debt fueled societiesImagine staring down the road, seeing dozens of half-built houses.

I’m not talking about houses that are actively under construction. And I’m not talking about decrepit old houses that need to be torn down.

I’m talking about houses that were partially built … and then nothing. No active construction. No wheelbarrows or cement mixers or sweaty workers taking cigarette breaks. Just half-built house after half-built house.

That’s what I saw during my trip to Jamaica last week. Don’t get me wrong; I spotted plenty of complete houses, too, but partially-constructed homes were far from rare.

“What’s the story here?” I asked my taxi driver. He smiled.

“People don’t have money to build a whole house all at once,” he said. “So they build one room at a time. It might take five, ten, fifteen years for the house to be complete.”

Welcome to a world that’s not fueled by credit.

Now, before I proceed with the rest of the story, let me make a disclaimer here and say that I’m certainly not an expert on Jamaican culture. I’m quoting a random cab driver. Take his words with a grain of salt.

That said, I’ve traveled to many countries – and was born in a country – in which credit is much, much tougher to obtain than it is in the U.S. In those places, many 25-to-35-year-olds don’t have the privilege of being able to get a mortgage as soon as they can prove two years of work history, a decent credit score, and a low debt-to-income ratio. Life is much easier here in the U.S.

Of course, life in the U.S. is also fueled by debt.

“People in America don’t have the money to build a whole house, either,” I told the cab driver. “They only own a small fraction of that house, maybe one-tenth or one-fifth of it. The bank owns the rest.”

Here’s the interesting juxtaposition between the two circumstances: In both situations, people will still spend 10 or 15 years (or 30 years) paying for a house. But in one scenario, that payment gets made in advance. In another scenario, the payment is retroactive.

America is one of the rare countries in which people as young as 25 or 30 can buy their own home, thanks in large part to cheap debt flowing from banks. And when youngsters are buying houses, they’re also buying furniture, rugs, TVs, dishwashers. When credit flows freely, consumption doesn’t end.

That’s bad when you’re keeping up with the Joneses. But let’s not be pessimistic. It also has a bright side.

Thanks to this situation – because we can buy now, pay later — we have mobility, which is awesome. We’re not stuck in our hometown. We can chase education and career opportunities in different cities and states.

When we move to a new city, where we don’t know a soul (and can’t live with family), we can borrow money to buy a house, or we can rent a house from a landlord who almost certainly borrowed money in order to provide us with that rental.

Ah, economic mobility. #FueledByDebt

Unfortunately, some people get stuck in cubicles paying down that debt. And their stress levels might shoot – um – through the roof. (No pun intended).

In countries where ordinary people have limited access to credit, houses are much harder to acquire. And (speaking of mobility) so are cars. It’s tougher to buy a set of wheels when you can’t roll out of bed, cruise to the dealership, and sign-on-the-dotted-line for “no money down” and “low monthly payments.”

When the average consumer can’t swipe an AmEx, the scene changes – both for better and worse. People aren’t stressed about their MasterCard balance, but they also deal with inconveniences that Americans can’t imagine – like living with their parents until they’re 40 or enduring tropical heat without an air conditioner.

Resisting the Mentality

So is a less-credit-fueled society good or bad?

It’s a mixed blessing. On one hand, our debt-fueled spending creates jobs. After all, someone has to wear a tie and work at a car dealership. Someone needs to underwrite mortgages and pre-approve your next Visa offer and sell you a mattress with a payment plan.

Then again, many things create jobs. Like the Internet. And your own imagination.

Speaking of which, business loans – which are a completely different animal than consumer loans – can elevate people to a new level in life. You snag a lucrative contract, but the client will pay upon completion, so you need to borrow money to buy a forklift for the job. Or you find a rental property that features 18 percent returns. Or you’re an optometrist who wants to borrow money to buy a LASIK machine so you can open your own clinic.

Opportunities come alive when people can leverage their businesses in wise, judicious ways. (That’s why I said that if I had a million dollars, I’d go into debt.)

On a broad scale, debt can serve a fantastic social good.

But here’s the rub: it’s easy to fall into a mentality of “buy now, pay later.” That type of thinking can be corrosive to your net worth if you spend that money on the wrong things.

Which is why I appreciate visiting societies in which loans aren’t the default method of payment, places where no one assumes that you’ll borrow the cash to buy your next car or house. It reminds me that borrowing money should be the rare exception, not the norm.

And it reminds me to be grateful for those rare instances in which I’m able to use leverage to elevate my status in life – rather than dig myself into a hole.

Should You Pay Down Your Mortgage or Invest the Cash?

Should you pay off your mortgage as fast as possible, or should you invest the money in the stock market or in investment real estate? Here's how to decide.

Should You Pay Off Your Mortgage or Invest?Touchy subject time: Should you pay down your mortgage rapidly OR invest the cash?

This question always brings out the punches, kicks and jabs. People have STRONG emotions about debt, even low-interest mortgage debt.

Through Afford Anything lens of “Stop Shouting, Start Thinking,” let’s walk through the potential consequences. You decide.

Everything Has Risk. Period.

Most people want to pay off their mortgage for three reasons:

#1: Emotion: Peace-of-mind
#2: Risk-Management: Reduce the chance of a foreclosure
#3: Savings: Lower their interest payments

These are all great reasons. But nothing is the “best” choice in a vacuum. It has to be compared to an alternative.

Alternative #1: Spend the money on champagne and strippers. Obviously a terrible choice.
Alternative #2: Invest the money. Okay, this could be a valid option. Let’s explore it.

Stocks, historically, have yielded an 8 percent long-term annualized return over the past few decades. Legendary investor Warren Buffet predicts that number will be closer to 7 percent in the coming years. For the sake of argument, let’s assume Buffet is right.

Now let’s rephase the question. Are you willing to pay extra to get rid of your mortgage faster?

That’s not a rhetorical question. Missed opportunity has its price. If you’re willing to pay the opportunity cost for the sake of reducing your risk — Great! Go for it! You might be leaving money on the table. If you’re okay with that, then you have your answer.

Notice I asked if you’re willing to pay the opportunity cost. That doesn’t mean you will. No one knows what the future holds. If the markets perform as they historically have done, you’ll miss opportunity. But if stocks tank, you’ll come out ahead.

There’s risk in every decision, even the decision to become debt-free.

Should you save or pay off debt? Or invest? Each option has pro’s and con’s.

Paying off your mortgage has:

  • Guaranteed interest savings
  • Limited upside
  • Unknown missed opportunities

Investing is:

  • Risky
  • Greater potential for upside
  • Stronger chance to capitalize on opportunity

Opportunity Cost

You have $100,000 in cash. (Congrats!) You also have a brand-new 15-year mortgage with a balance of $100,000, at 4 percent. (For simplicity sake, I’m leaving taxes out of the equation.)

Scenario A: You pay off your mortgage. You save $33,143 in interest payments. You invest $739 per month, the amount that would’ve been your mortgage payment. You contribute every month for 15 years and it grows at 7 percent. At the end of the term, your portfolio is worth $237,706. Hooray!

Scenario B: You invest the entire lump sum in the market. You make no additional contributions. In 15 years, your portfolio is worth $284,894. You’ve also paid $33,143 in mortgage interest, which you subtract out. Your net gain is $251,751. Wahoo!

Under this scenario, you’ve lost the opportunity to make $14,045 by paying down your mortgage early. Boo! That’s a strong argument for investing.

On the other hand, you’ve enjoyed peace-of-mind, which DOES have a value. You have less risk, higher liquidity and more flexibility.

Is that peace-of-mind worth $14,045? You decide.

Scenario C: You invest the money. The market tanks. You lose your job. Your house gets foreclosed on. Your spouse leaves you, your dog bites you, and even your goldfish won’t look at you anymore.

It’s a worst-case scenario, but it’s possible. Now the $14,045 looks like cheap insurance.

(What about borrowing to invest in real estate? Here’s my take.)

Quit Being Ideological

You know what’s funny about being a personal finance blogger AND a real estate investor? I hear ideologues on both sides of the aisle.

Finance bloggers, as a group, tend to have knee-jerk reactions to the word “debt.” Debt bad! Debt bad!

Real estate enthusiasts tend to have the opposite reaction. Gimme leverage! More and more and more leverage!

Half the emails I receive about this topic come from people who say, “Are you going to pay off your houses as fast as possible?” The other half ask, “Why aren’t you borrowing more?!”

Don’t make decisions based on ideology. Everything financial, even debt payoff, comes at a price. Everything carries risk. Risk wears different costumes, appears in different forms. But it’s there.

Avoid knee-jerk reactions and zombie ideology. Weigh the risks. Make a spreadsheet. Calculate missed opportunities. Imagine the worst-case scenario and ask yourself if it’s something you can live with.

Make choices based on information, not ideology.

Then decide for yourself.


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Stop Worrying About the National Debt

Lately everyone’s been panicking about the U.S. debt.

If you watched any TV news over the past 2 weeks, you heard an earful about the national debt. If you picked up any newspaper, you noticed the national debt dominating the headlines.

If your friends are anything like mine, Friday night dinnertime conversation turns to the national debt. After the second beer, someone starts ranting about how our country is buried in debt to China. Someone else counters that our citizens have less health care and worse education than Europeans. A third person chimes in with a rant about taxes. This triggers an all-out dinner table war.

This is the point where I quietly excuse myself and slip off into a corner, where I start a new conversation about something — anything — that I can actually DO SOMETHING ABOUT.

You see, I’m a firm believer that you should spend less time worrying about the nation’s finances and more time thinking about your personal pocketbook.

How many people do you know who argue about the national debt, taxes and health care reform, while failing to contribute to their 401k?

How many people do you know who discuss how the politicians and/or corporations are “ruining the economy” while they pay 10% on their car loan?

I’m going to mount my high horse for a second to give a blunt piece of advice: Stop blaming the country for your problems, and get to work.

What Debt Crisis? What’s Going On?

For those of you living under a rock (and for the benefit of my non-U.S. readers), the national debt drama goes roughly as follows:

  • America borrows a bunch of money.
  • America hits its $14.3 trillion “borrowing limit” — the debt ceiling — in July 2011.
  • (Imagine you hit your credit card limit and Visa/Mastercard stopped letting you charge anything else. That’s the situation the U.S. is in, except our ‘credit limit’ is self-imposed.)
  • Americans realize that if the “borrowing limit” isn’t raised, our country will default on our loans. Yikes! U.S. goes into panic mode.
  • International credit ratings agencies investigate downgrading the America’s national “credit score” from AAA (the highest possible score) to a lower score, like AAA-(minus). This would raise the interest rates on our $14.3 trillion debt, which would reverberate throughout the country in the form of higher mortgage, tax and inflation rates. Further panic ensues.
  • U.S. stock market plunges 6.7 percent. “This is only the sixth time the Dow has dropped eight straight days in more than 30 years,” says the Wall Street Journal.
  • Politicians from both parties bicker like insolent children.
  • Life imitates art Congress: ordinary Americans argue about the national debt crisis while failing to fund their own retirement accounts.

The Anti-Debt Politicians Carry a Credit Card Balance

I’d laugh if it wasn’t so sad: some of the most vocal anti-debt politicians carry huge credit card balances.

Senator Mike Lee of Utah declared that Congress is “burying our children … under a mountain of debt.”

But as a CNN review of his financial disclosure forms shows:

Lee had amassed at least $15,000 in credit card debt and had a $50,000 line of credit at a Utah bank as of late last year.

He’s not alone … Rep. Tim Griffin of Arkansas had at least $15,000 of debt accumulated on an American Express card, according to the forms. Griffin … has recently said Washington has “a spending addiction.”

Note that the report said at least $15,000 in debt. The financial disclosure forms give a range of figures: Griffin’s credit card debt ranges somewhere between $15,000 to $50,000.

The report continues:

Rep. Kevin Yoder … said in a recent press release, “Washington needs to cut up the credit cards.” But Yoder’s own form shows he amassed at least $15,000 in what’s called a “revolving charge account” with Citigroup.

I’m not telling you this to poke fun at politicians. Seriously. I’m not trying to take a cheap shot at Congress, nor am I trying to make a partisan statement. Notice that I omitted any mention of their parties: that information is unnecessary, and it would only distract from the larger point.

I’m telling you this story because these Congressmen’s personal finances are a reflection of what’s happening across the country. Many Americans get caught up in the nation’s economy but fail to take care of their own bank balance.

They rail against higher taxes and more spending in Washington, but won’t cut their cable bill when their checking account balance gets slim. They’ll complain that Social Security is going bankrupt, but they won’t open a retirement IRA.

They’ll read books by partisan talking heads and political pundits, but they won’t read a book about step-by-step financial planning in your 20’s, 30’s, 40’s and 50’s.

It’s easy to think that if the government solves its problems, we’ll all be okay.

Guess what: you’re the only person who can make your own life okay.

I have no control over how generous Social Security will be in 30 years. I can’t control the inflation rate. I can’t control taxes. And I won’t waste my time trying.

I can make sure I’m saving for retirement every year, so that I don’t have to rely on a government check when I’m elderly.

I can make sure I have a decent emergency fund, so if taxes rise, I’ll have enough to pay the bill.

You get the point, so I’ll leave you with this political cartoon from the New Yorker that summarizes it all:


Photo courtesy Kevin Krejci.

Forget Your Debt. Just Forget About It. Really.

What if the most common strategies to repay debt are wrong?

Two popular methods are used to repay debt. One focuses on the interest rate; the other focuses on “small wins.”

I recommend reading this post if you want a solid understanding of these two methods. Here’s the executive summary: the “Debt Stacking” method says you should repay the debt with the highest interest-rate first. The “Debt Snowball” method says you should repay the smallest debt first, regardless of its interest rate, so you can feel the psychological “win” of crossing it off your list.

I think both of these fall short. So today I’m going to propose a third method: the Forget Your Debt method.

The Status Quo Stinks

The Debt Stacking method makes logical sense. You’ll save the most money if you repay the loans with the highest interest rate.

The problem is that many people have a hard time motivating themselves to repay a large debt, regardless of its interest rate. No matter how much money they throw at a big debt, the balance never seems to subside. The person feels like they’re not making progress. It’s akin to being on a diet but never seeing the pounds melt away. They become discouraged and quit.

The Debt Snowball method, which obliterates the smallest debt first, can keep you motivated.

But it comes with a large price tag. You’ll make minimum payments on high-interest debt — which means the compounding balance will climb higher and higher.

For anyone who runs a spreadsheet to compare these two options, the hundreds — maybe thousands — of dollars it costs to use the Debt Snowball method is a bitter pill to swallow.

Switch Your Focus

The problem with both strategies is that they both focus on the wrong thing.

The interest-rate method focuses entirely on the numbers, but fails to take psychology and emotion into account. The Debt Snowball method focuses entirely on psychology and emotion, but fails to honor the numbers.

What if there was a method that focuses on both?

Forget Your Debt

Both the interest-rate method and the Debt Snowball method share one trait in common: they force you to think about your debt.

Thinking about debt stinks. It causes debtors to feel trapped, shackled. It breeds discouragement.

I want you to do the opposite: forget about your debt.

You’re Already Free

Debtor’s prisons were eliminated in the mid-19th century, but focusing on debt makes people feel imprisoned.

You’re no more “free” when you repay your debt than you were when you carried debt. (The other way of looking at it: you’re just as free with debt as you are without.)

You still have to put groceries on the table, keep the electricity on, fill your car with gas, put clothes on your back, save for retirement, send yourself or your kids to school, write checks to your insurance company and give the government your tax dollars. Fail to do even one of these things and you’re in serious trouble.

So why do people feel free when their last debt is repaid? It’s because they’ve spent too much time and energy focusing on debt. They should be concentrating on the bigger picture – and that starts with eliminating the “d” word.

Eliminate the D-Word

Repaying debt is like dieting. If you focus on deprivation, you’ll fail.

Tell yourself “I shouldn’t eat chocolate … and cupcakes … and warm brownies with a delicious scoop of French Vanilla ice cream on top … and I shouldn’t eat pizza with spicy pepperonis and ground sausage and fresh mozzarella … and a steaming bowl of chili with an ice-cold beer … and I shouldn’t have bacon, eggs and a buttermilk biscuit … ”

Neither your brain nor your stomach hears the “I shouldn’t.” If you think about the fact that you’re dieting, you’ll fail.

The trick to dieting is to focus not on the deprivation, but on the abundance. Instead of thinking about all the foods you shouldn’t eat, think about the foods you get to eat: blueberries, quinoa, fresh-caught salmon.

Diets don’t work. Embracing a healthy lifestyle does. Eat more of what’s good instead of less of what’s bad.

A successful diet requires eliminating the “D” word — “diet”.

Repaying debt is the same way. The fastest road to discouragement is to focus on debt and deprivation. You shouldn’t go to the movies. You shouldn’t go to dinner with your friends. You shouldn’t get a haircut.

What a terrible way to live.

Successfully getting out of debt also requires eliminating the “D” word. Shed your “debtor” identity.

Focus on more of whats good rather than less of what’s bad. You’re not trying to repay debt. You’re trying to build wealth.

Adopt a ‘Build Wealth’ Mindset

Adopting a wealth-building mentality can be tough if you’re used to thinking of yourself as a debtor. You have to switch from a mindset of sacrifice to a mindset of creating abundance. Here are a few pointers on how to do it:

#1: Eliminate the D-Word. Cross out all written references to that word. Announce to your significant other, your family and your friends that you’re not allowed to say the D-Word. Place a jar on your kitchen counter: every time you say the D-Word, you have to contribute a dollar to the jar.

#2: Read About Wealth-Building. Buy books, read magazines and blogs, and listen to podcasts that focus on building sustainable wealth. Be choosy. Stay away from media that focuses on cost-cutting as an act of deprivation. Focus on media that celebrates wealth-building as an exciting opportunity.

#3: Remember: You’re Already Free. Take a look at your bills each month. You have expenses just like everyone else: groceries, electricity, gas. Maybe a payment to your credit card is among your expenses, but guess what? Lots of debt-free people have expenses you don’t have, such as caring for an elderly parent or supporting 4 kids.

Getting out of debt won’t set you “free.” True financial freedom comes from having passive investments that make enough money to cover your cost of living. Most people don’t experience that, and those who do enjoy it have spent a decade or more relentlessly pursuing it.

#4: Get Excited About Opportunity. There is a wealth of opportunity (pun intended) to build your net worth. Pick your favorite methods: you can invest in real estate, buy dividend stock funds, start a business … the options are endless. Focus on the opportunities at your fingertips. Once you switch to this frame of thinking, you’ll notice a huge opportunity staring you in the face — the opportunity to save $100 a month or $200 a month in interest payments. This isn’t your get-out-of-debt plan; this is one of many opportunities in a grand wealth-building lifestyle. If you make a few extra payments on that MasterCard balance, you’re not “climbing out of debt;” you’re taking advantage a stellar opportunity.

#5: Make It Visual. Post photos of all the wealth-building opportunities you want to capitalize on. If you want to own rental properties, put up pictures of a building in a location you love. Want dividend stocks? Put up a graph of historic returns. Want to see how much an extra $100 a month towards your car loan will save you? Draw it, sketch it, graph it, and hang it on your walls.

#6: Write an Opportunity List and post it somewhere you see occasionally. If you post it somewhere you see everyday, you’ll grow numb to the sight of it; it will start to blend in with the background. You’re better off posting it somewhere you occasionally see, where it will catch you by surprise. Stick a copy in your sock drawer. Paste a copy to your glove compartment. Try outlandish: Tape it to the inside of your freezer, so you only see it when you open the freezer door.

Thanks to Jason Rogers, Gloria Payne (Morning Glory), Alan Cleaver and Mene Tekel for the photos.

Debt: Should You Use Reason or Emotion?

What would you do if reason says one thing but your heart says another?

That’s the predicament many people find themselves in as they search for the best strategy to repay debt.

Reason says you should repay the debt with the highest interest rate first. Your emotions say to — well, really, they say to run and hide. Stop answering your phone. Maybe flee the country.

Barring those extremes, your emotions tell you to repay something, anything, regardless of its interest rate, so you can feel the relief of checking at least one debt off your list.

Today we’ll take a look at the pro’s and con’s to both of these strategies.

The Most Reasonable Plan

Reason says that debt is bad, not because it makes you feel icky, but because it negatively affects your bottom line, your personal balance sheet.

High interest rates have the worst effect on your bottom line; low interest rates have the least effect. It makes sense to repay high-interest debt first, the reasonable strategy says.

Based on logic alone, this would be your step-by-step action plan:

  1. Make a list of all your debts.
  2. Rank the list in order from highest-interest to lowest-interest.
  3. Make the minimum payment on all debts.
  4. Throw every spare penny into making extra payments on the highest-interest debt.
  5. Congratulate yourself when the highest-interest debt is repaid.
  6. Throw every spare penny into making extra payments on your second-highest-interest debt (which is now your highest-interest debt).
  7. Repeat until finished.

There are some variations on this plan — financial writer Suze Orman suggests making the minimum payment plus an extra $10 on all debts while plowing the rest of your money into the highest-rate debt. Presumably this gives you the satisfaction of seeing the balances on all your debts recede (or at least not accelerate) while you’re tackling the worst offender.

(Suze recently changed her mind and started advising people to make only the minimum payment on ALL debts while building an 8-month emergency fund, but that’s a different story.)

The Emotionally Satisfying Plan

Recently, another method has grabbed the headlines. Known as the “debt snowball,” this method promises to be the most emotionally satisfying, even if it costs you more in interest fees.

The debt snowball method, popularized by financial radio host Dave Ramsey, goes like this:

  1. Make a list of all your debts.
  2. Rank the list in order from largest to smallest.
  3. Make the minimum payment on all debts.
  4. Throw every spare penny into the smallest debt.
  5. Congratulate yourself when the smallest is repaid.
  6. Throw every spare penny into making extra payments on your second-smallest debt (which is now your smallest debt).
  7. Repeat until finished.

I admit when I first heard about this, I was shocked — why would he recommend a method that could cost you hundreds, if not thousands, of extra interest fees?

It made no sense. It smacked of bad advice. I even contemplated writing an anti-debt snowball post.

But then I started reading personal stories of people who swear this method helped them pay off a mountain of debt. Jamie Tardy, the author of one of the first financial blogs I started reading, Eventual Millionaire, credits the debt snowball method for helping her repay $70,000 in debt when she was pregnant.

We paid off the first student loan very quickly. It took a few months to pay off the Jeep, and it felt so great to eliminate two payments per month. Then we had the two huge loans next.

The psychological win of eliminating one monthly payment — and then another monthly payment — gave Jaime the motivation to live the demanding lifestyle necessary to repay debt: she worked around the clock despite being 8 months pregnant, she never ate at restaurants, and she sold every possession she could imagine — her weight bench, her kayak, her wine rack.

So What’s the ‘Best’ Strategy?

While I’ve become sympathetic to the snowball method — particularly after hearing firsthand accounts of how much it has helped people — I can’t help but feel queasy about all the extra interest payments incumbent in this method.

So I’ve devised a third plan, one that brings reduced interest payments in sync with human psychology. I’ll unveil it on Monday in a detailed post. (Update: Here’s the post!)

In the meantime, readers, sound off on the two debt repayment plans listed above — the rational method and the emotional method. Have you tried either of these? What works for you?

Not in debt? Read about the “Savings Snowball” method to accelerate your savings.

Photo #1 courtesy Flickr user Kamshots.
Photo #2 courtesy Flickr user Paul Stevenson.

Diets and Debt: The Psychology of Money

I’ve watched friends diet and fail, and I’ve watched friends spiral into debt, recklessly invest, or fail to save for retirement.

Each time I’m reminded that the fundamentals of money management are similar to the fundamentals of weight loss:

#1: Perfect is the Enemy of Good.

It’s far better to have a “good” plan you’ll follow than to have a “perfect” plan that’s too tough to follow.

#2: Think Long-Term.

Supermodel Kate Moss is famous for saying “nothing tastes as good as skinny feels.” Nothing you buy is as rewarding as having true wealth and being financially free.

Researchers found that it’s not what you own that makes you happy. Happiness comes from the freedom and choices that your money affords you.

#3: It’s Not About How You Look. It’s About How You Feel.

Have you noticed how some people who have reached their target weight continue to eat healthy and exercise? When you ask what their motivation is, they almost universally reply: “This makes my body feel better.” They don’t emphasize their flat stomach – they emphasize the way they feel after jogging five miles.

Ask wealthy people why they continue to save, and they’ll almost universally say: “Because it makes sense.”

Money is a weak motivator if your only goal is outward appearance – designer clothes and sports cars. Money is a great motivator if your goal is — like with healthy eating — to feel healthy from the inside out.

Financial security lets you leave a job you hate, change careers, start a business or feed a huge family. In other words, you’ll feel more free and in control.

#4: Small Splurges Don’t Matter. Long-Term Habits Do.

If you’re trying to maintain your waistline, one Friday night splurge on a steak dinner with margaritas and cheesecake ultimately won’t matter. What matters are your long-term habits: do you follow that Friday night splurge dinner with a bowl of oatmeal, handful of almonds and a jog on Saturday morning? Or do you follow that Friday night dinner with a bacon-and-fried-eggs brunch?

The slow-and-steady habits – not the occasional splurges – create results.

The same is true of your wallet. Enjoy that expensive Friday night steak – just follow it with healthy habits for the rest of the week.

#5: Crash Diets Don’t Work.

Extreme frugality stinks – and is counterproductive. Being too cheap (or too hungry) leads to feeling deprived – which leads to overindulging.

If you’re hungry, you’ll more likely to gorge on bacon and nachos. If you’re living too frugally, you might snap one day, blowing your savings on a Louis Vuitton handbag.

The health industry warns you against “yo-yo dieting” – and I’m warning you against “frugality fatigue.” Same idea, different applications.

#6: Consistency is Key

Am I repeating myself now? It ridiculous to eat only raw veggies for a week if you know you’ll splurge on chocolate and cheeseburgers on Friday. You’re better off adopting a sensible eating plan that you can consistently stick to. Remember lesson #1: perfect is the enemy of good.

Want to learn more about the Psychology of Money? Check out these posts:

If I Had $1 Million Dollars, I’d Go Into Debt

Yesterday I read three great posts all on the same topic: what would I do if I won a million dollars?

  • One blogger says she’d pay off debt, save for retirement, take a vacation and remodel a home.
  • Another blogger would “stare in sheer disbelief at the balance in my bank account.”
  • And a third blogger would be watching penguins in Antarctica.

So I decided to write my own post: what would I do with a big, fat million?

Caution: The answer might shock you.

I would willingly – deliberately – go into debt.

Note: All figures are based on 2011 retirement limits.

#1: Pay about 33% in taxes. There goes $330,000. Bye-bye!

#2: But wait! I can reduce my tax burden by maxing out my Solo 401(k). As of the time of this writing (2011), that’s a $16,500 tax deduction!

#3: If I got that million prior to April 15, I could retroactively max out the previous year’s Solo 401 (k). Another $16,500 in deductions!

#4: If I win the million between Jan. 1 and April 15, I’ll retroactively max out my previous year’s Roth IRA. There goes $5,000!

#5: Max out my Health Savings Account (HSA) contribution for a $3,050 tax deduction.

#6: Gee, how much do I have left? My taxable income, thanks to all the deductions, is $963,950. The top tax bracket is 35%, but it’s marginal, so let’s say I’m paying, effectively, 33% in taxes — I can kiss $318,103 goodbye.

#7: Now I have $645,847 remaining. (Wow, a million goes fast!)

#8: My goal is financial freedom, which comes from a steady stream of passive income for the rest of my life. There are a few ways to achieve this:

  • Laddered CD’s, which are the safest but lowest-yielding
  • Bond funds, which are also fairly safe but low-yielding
  • Exchange Traded Funds (ETFs) that track stocks that pay high dividends
  • Real estate: Become a landlord, collect rent. To make this “truly passive,” hire a property manager.

I have a pretty high risk-tolerance. So I’d skip past the laddered CD’s and bond funds, and divide the money equally between rental properties and commission-free ETFs that track dividends — like Vanguard’s Dividend Appreciation ETF (stock symbol: VIG) or Vanguard’s High Dividend Yield ETF (stock symbol: VYM).

So … how much do you make each month?

Let’s assume I put half the remaining money into ETF’s that track dividends: that’s $322,923 into dividend-yielding ETFs. Assume I get an average of a 4 percent dividend payout each year: that means I’m collecting a cool $12,916 every year without having to lift a finger.

If the stocks within that fund rise, great. If they fall, boo. But stock growth isn’t the point; to me, that’s only a hedge against inflation, nothing more. The point is that they’re sticking almost $13,000 in my pocket each year.

But … that’s not very much!

(Wo)man cannot live on $13,000 alone. Which is why I’ve diversified, and invested the other $322,923 into rental properties.

There are two ways I could do this: buy houses in cash, or cut the money up into lots of little down payments and take out a bunch of mortgages. Because I’m 27, I’m going to take out a bunch of mortgages. That’s right … If I had a million dollars, I’d go into debt.

Let’s investigate both of these scenarios:

The Cash Scenario:

I buy a triplex in Atlanta for $220,000 and spend $100,000 fixing it up. (Poof! There goes all my money.)

I collect $1,000 per month from Unit 1 (a 2-bedroom), $800 per month from Unit 2 (a 1-bedroom), and $650 per month from Unit 3 (a smaller 1-bedroom). Gross monthly rent: $2,450.

I pay $250 per month in insurance, $200 per month for water, and $300 per month in property taxes ($9,000 per year). I also assume a 10 percent vacancy rate. I manage the property myself because I don’t want to lose another 10 percent to a property manager.

This means each year, I’m collecting a net total of $17,460 on my investment of $322,923. This is actually a better return than the $13,000 a year I’m getting from my dividend ETFs, which makes me happy. Between the ETF’s and the rental property, my million dollars is netting me a total of $30,460 per year in passive income. If I wanted to hire a property manager and make the investment TRULY passive, I’d net $28,714 each year.

(Now are you starting to understand why so many self-made millionaires drive 10-year-old used Toyotas?)

But let’s say I want to “live large” — or at least live a lifestyle that requires more than $28,000 a year. What’s a girl to do?

The Debt Scenario:

I chop up the $322,923 into a series of down payments for multi-unit houses. (Multi-unit houses are the best rental properties because your overhead is lower … you only have to replace one roof, maintain one yard, pay one insurance policy.)

Each multi-unit property I want to buy costs $300,000. I plunk down a 20 percent down payment on each — that’s $60,000 per house. At that rate, I can afford 5.3 houses (let’s call it 5 houses, after closing costs).

Because I’m getting an investor loan, rather than a primary mortgage loan, my interest rate is higher: 5.5 percent, rather than the 4.5 percent that homebuyers with good credit are receiving in 2011. I get a 30-year fixed-rate mortgage, and don’t have to pay primary mortgage insurance because I’ve plunked down 20 percent. This means my monthly mortgage payment is $1,362.

My insurance, taxes and water for each house remain the same, at $700 per month in total. My gross rental income for each house remains the same, at $2,450 per month.

Add my expenses: $1,362 + $700. Subtract these from my monthly rental income: $2,450. I’m now left with $388 in my pocket each month.

Multiply by the 5 houses I own: this means I receive a passive income of $1,940 per month … which equals $23,280 per year.

Add this to the yearly $13,000 I’m getting from that dividend-paying ETF, and I now have $36,280 per year in passive income.

Debt Can Be Awesome — In Moderation

By financing those 5 properties — rather than paying in cash for 1 — I’m adding $6,000 to my pocket in passive income each year.

As the years pass by, and inflation kicks in, I can increase the rent (at the rate of inflation), though my fixed-rate mortgage payment will stay the same … which means the amount I’m collecting will grow every year.

At the end of 30 years, when I’m 57 years old, I’ll have 5 houses completely paid-off and will be raking in an extra $81,120 per year ON TOP OF the inflation-adjusted $36,280 I’m already collecting.

($1,352 monthly mortgage x 5 houses x 12 months = $81,120 per year).

This is why access to credit can be a very, very good thing.

Anyone can be wealthy if they live long enough.

Thanks to compounding interest — which Albert Einstein famously said is “the most powerful force in the universe” — anyone could be wealthy if they live long enough.

Unfortunately, life is short. And if you get started investing late in the game (i.e. past age 30), your investing life is even shorter.

That’s why access to credit can be so powerful. It accelerates time by letting us borrow money to invest. For every dollar we put in, we can buy 5 investment properties instead of 1.

Obviously, access to credit can work against us as well … when we use that credit to buy weddings, trips to Aruba, and jewelry. But used wisely, credit can be the key to riches.

That’s the principal behind micro-loans in developing countries: that millions of people are poor precisely because they CAN’T go into debt. That global poverty is partly the result of a lack of access to credit.

On a personal note, one of my biggest frustrations is how hard it is to secure a loan to buy investment real estate. Banks want 25 percent down payments, 18 months of work history with the same employer, a strong monthly salary, and … on and on.

If I had a million, I’d leverage it. I’d go into debt. And I’d come out stronger in the end. But I’d still be driving a used car.

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