Avoid A Debt Avalanche This Holiday Season
Our financial troubles in the monastery started with a couch. That was our first big credit card mistake — a silly couch. We made our old one last as long as possible, even throwing a sheet over it to hide the Jackson Pollock-like stains.
Then one Friday evening, while watching a rerun of a Marx Brothers movie, the wooden spine cracked, sending us backward onto the floor in a flurry of monastic robes.
No one was hurt physically, but like more than 60 percent of Americans, we had no emergency fund to cover an unexpected expense. So we put our new couch on a high-interest credit card. The only thing we understood was that we would have a minimum payment of $30 a month.
Not a problem, right?
Wrong. Oh my, was that wrong.
First, let’s look at the interest payments. Interest is the money that you pay for the privilege of borrowing money. At 19 percent annual interest over five years, we paid an extra $659 for a $1,200 couch.
That was the beginning of the Debt Avalanche.
Here is how debt avalanches out of control: It’s because of the time value of money. This basic principal explains how debt will destroy your wealth, while investing will grow it.
Money, like people, has an earning capacity. Let’s say the “minimum wage” for money is what you’d get if you sent your money to work at a bank by depositing it in a guaranteed money market account or Certificate of Deposit (CD). Around 1 percent to 2 percent right now. Not great.
But just as higher-risk jobs pay more than minimum wage, higher-risk investments should offer better returns. Money put to work in the stock market has, on average, generated a historical return of around 10 percent per year.
To illustrate how the time value of money can grow your wealth, let’s say you invested $100 in an index-based stock fund, and earned $10 in the first year. The magic begins to happen in the second year.
Now you have $110 working for you. If the market goes up 10 percent in year two, you can expect to make 10 percent on $110, or $11, bringing your total to $121. Reinvest all your earnings, year after year, and your money should grow exponentially.
After 40 years of 10 percent annual returns, your $100 will be worth $4,526. This is called compound growth. Money, invested over time, grows. That is the time value of money.
Now let’s return to the Debt Avalanche. How does a credit card company work? They could invest their money in the stock market, so why are they giving it to you or me?
Simple: Because they’ve found a high-risk job for their money, from which they expect high returns. The work is dangerous because a percentage of borrowers will go bankrupt or fail to pay their debts. To make up for that risk, credit card companies charge us a lot to use their money.
Back at the monastery, we could only afford to make minimum payments on our credit cards, and we added other small purchases each month. As a result, our total balance just kept growing and growing.
Nineteen percent on a $1,200 couch over 40 years without paying down the balance compounds to a whopping $1.2 million. That isn’t a typo. That’s a Debt Avalanche. Credit cards love it when you get stuck in the Debt Avalanche.
It is like signing up to become their indentured servant for life.
As I painfully learned, the secret to growing wealthy is to make compound interest work for you, not against you. This is why capitalists buy investments that appreciate over time. In contrast, consumers buy things (like couches) that depreciate or cost them money over time.
As we head into the holiday shopping season, don’t get massacred. Give your family the best gift possible — ditch your credit cards.
And if you really want to gift something of value, how about something that appreciates, like a Custodial IRA or college savings account?
Doug Lynam is a partner at LongView Asset Management in Santa Fe and a former monk. He is the author of From Monk to Money Manager: A Former Monk’s Financial Guide to Becoming A Little Bit Wealthy — And Why That’s Okay. Contact him at firstname.lastname@example.org
About This Contributor
Making Money A Force For Good
"A monk, a Marine, and a money manager walk into a bar . . . actually, they wrote a book and they are all the same person! Doug Lynam is one of the most interesting people I know." – Scott Dauenhauer