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book excerpt

Rich by 40 by Lesley Scorgie.

This is an excerpt from Chapter 5 of Rich By 40: A young couple's guide to building net worth, written by Lesley Scorgie. You can read a Q&A with the author here.

Debt - Get Out and Stay Out Curtis, twenty-five, owes $25,000 in student loans, $10,000 on a vehicle loan, and $3,000 on his credit card. He graduated two years ago and has been working full time since. Each month, he pays down $400 on the student loan, $400 on the vehicle loan, and $300 on his credit card. Curtis feels really strapped because his take-home pay is $2,500 a month and after paying his debts, he doesn't have much left over for rent, food, clothes, entertainment, and savings. He feels like he's not getting ahead.

Having debt can feel like a ball and chain around your ankle, making it difficult to move forward. If you have any debt or feel that it is getting in the way of having the life you really want, pay close attention to this chapter. You will increase your debt knowledge and learn the skills to tackle your debts faster and smarter.

Getting a handle on your debt and making progress toward reducing it is critical. Although it requires your time and energy, it is a huge demonstration of your ability to manage your finances.

Here are the facts: most Canadians have some form of debt. Access to credit cards, loans, mortgages, and the like has become easier and more prevalent than in previous generations. You can't walk through an airport or shopping mall anymore without being approached to sign up for a credit card or deferred-payment plan. Our generation has grown up using debt regularly to afford our increasingly expensive lifestyle-and yes, it is more expensive to live now than it was fifty years ago.

The Certified General Accountants Association of Canada published a report in May 2009 called "Where Has the Money Gone: The State of Canadian Household Debt in a Stumbling Economy." The report revealed that Canadians owed $1.3 trillion ($900 billion in mortgages and $400 billion in consumer debt). That's a lot of debt. And that number is on the rise, up from $1 trillion the previous year. Debt has risen steadily over the past decade at an average of 5.5 per cent annually, which is slightly higher than the average increase in inflation of 3.5 per cent. Canadian Business reported that in 2009 Canadians owed a total of $181 billion on their lines of credit whereas in 2004 they owed $100 billion and in 2000, only $50 billion.

So what does that mean per household? According to Statistics Canada, in 2005 Canadian households owed $9,000 on their lines of credit, $2,400 on their primary credit cards, $9,000 in student debts, $11,000 in vehicle loans, and $6,000 in other debts (typically credit cards or consumer loans). This totals $37,400 in consumer debt per household. Since 2005, these numbers have increased. For example, the average graduate from a bachelor's program has at least $20,000 to $30,000 in student-related debt-far more than a few years prior. Finally, as of May 2009 approximately 85 per cent of Canadians carried a balance on their credit card.

Canadians are heavily in debt, but what can we do about it? Overall, the first and the best debt-reduction strategy I can offer is this: stay out of debt. But for many, I realize this strategy isn't ­possible. So, rather than dismissing debt completely, I want to discuss debt reduction and navigation. I believe that having debt is now, unfortunately, the norm. But managing debt properly is your key to getting ahead and building the lifestyle you really want.

Debt 101 The money you originally borrow is called principal. To borrow money, you must pay a premium, which is called interest. Interest is the cost associated with borrowing money.

Far too often, I hear, "The total cost of borrowing doesn't really concern me, just the monthly payments." When it comes to responsible money management, this attitude is dangerous. Of course a monthly payment seems reasonable; it's the total cost of borrowing (principal plus interest), broken up into so-called easy and affordable monthly payments. This is a much easier sell for salespeople than trying to move a product at the real price. Low monthly payments can trick you into thinking you're getting a good deal when you're not. A monthly payment of $100 when you're being charged 20 per cent in interest is never a good deal! Take a good hard look at the real cost of borrowing.

Interest is typically based on risk. If you're likely to default (not pay) on your loan payment, you'll pay a lot more interest than someone who's less likely to do so. The way creditors determine who is and is not a risky person to lend to is based on your credit history. If you have a good history (i.e., you haven't missed payments), you're a less risky candidate than someone with a bad history of repayment.

Building good credit can be done by making payments on time on debts that are in your name. You don't build credit if you're a co-applicant on a credit card or loan. So, to build positive credit, borrow in your own name and make your payments on time.

Know the Difference For debt management to make sense, you must first know the difference between good and bad debt. Good debt is debt that helps you grow your asset base: things you own. A mortgage, investment loan, business loan (for business investment), and student loan fall into this category. A mortgage on a home that appreciates steadily over the long term, for example, is a tool that helps you grow your assets. Good debts tend to cost the consumer a great deal less in interest.

Bad debt doesn't help grow your asset base. Credit card debt, car loans, and other types of consumer loans are typically used to purchase depreciating assets. A car is not an asset. The value of a standard vehicle doesn't appreciate in value over the long term; indeed, its value plummets the moment you drive it off the lot. Other than the very rare case-when someone drives a fancy antique Ferrari-99.9 per cent of vehicles won't appreciate in value, hence they aren't assets. Car loans are bad debts. The payments you're making on your living-room furniture would fall into the bad debt category as well. Interest rates on bad debts tend to be high.

When it comes to debt, your best strategy, besides avoiding it completely, is to borrow to invest in assets and avoid debts that don't help increase your net worth.

Strategies for Good Debt There are two keys to success with good debt. The first: purchase assets that are expected to grow. To figure out if your asset is positioned for long-term growth, do a little research before you buy. For example, research the neighbourhood where you're thinking of buying a home to determine if the area is expected to grow.

Second, ensure the interest rate on the debt is lower than your expected return on the asset. So, for example, you might take out a two-year loan at 6 per cent to make an investment in a stock that is expected, not guaranteed, to return 10 per cent annually for the next two years. In this case, your expected return is 4 per cent higher than the cost of borrowing. Or, think of it this way, you take out a thirty-year mortgage at 5.5 per cent and your house is expected, not guaranteed, to appreciate in value at 6.5 per cent (the expected return is 1 per cent higher than the cost of borrowing) over the next ten years. In both these examples the expected return on the asset is greater than the cost of borrowing.

Strategies for Bad Debt Bad debt results when you use credit to purchase a consumer item that doesn't grow in value. For example, if you buy a big-screen tv and pay for it on a store credit card, not only will that tv be worth next to nothing in two years, but also you'll be paying the original ticket price plus the high interest on the card.

Bad debt has zero return on investment other than that it might increase your personal happiness factor until the next latest-and-greatest product hits the market. Your consumer spending quick fix is both expensive and worthless in the long run.

The Truth about Credit Cards Steven is thirty-two years old and makes $50,000 per year. He enjoys golfing, attending sports games, has a nice car, and takes off to Vegas a few times each year. For years, he has managed his credit card balances (a total of $10,000) by making combined monthly payments of $500 toward them. Steven justifies some of his spending because he gets points on his credit card toward flights that he uses for his trips, but he's frustrated because he can never seem to pay the balances down.

Credit cards are a convenient way to pay for things you want whether you can or cannot afford to do so. The truth is, if you don't carry a balance, and if you charge an item to your card, you've got thirty days to pay it off without paying interest on the purchase. If you can't pay off the balance, your credit card company will charge interest, typically 17 to 22 per cent, on your purchase. Remarkably, many store credit cards charge even higher interest rates-some in the range of 28 or 29 per cent. If you charge a purchase on your credit card while carrying an existing balance, there is, as of May 2009, a twenty-one-day grace period before you'll be charged interest.

Credit card debt accumulates quickly and can be difficult to pay off for three reasons: first, high interest rates; second, credit card companies set minimum payments between 2 and 6 per cent of the outstanding balance (or $10, whichever is highest), which barely covers the interest charges on the card; and third, interest is calculated and charged daily, not monthly (but, you only see one interest charge per month on your credit card bill). You'll also need to keep in mind that as you pay off your credit card balance, your minimum payment will also decline-declining credit card balance means the required minimum payment is constantly recalculated because the minimum payment is typically set at a percentage of the balance, thus it decreases. This can extend the amount of time it will take to pay off the balance as some consumers will simply pay only the minimum payment.

This is why owing money on a credit card is financially lethal, forcing us into a situation where we are continually paying for the past rather than investing in the future!

So, how did we get here? Over the past few decades, credit has become readily available. Starting in high school, credit card companies start sending applications to students with large credit limit guarantees. So, from a relatively young age, we become very ­comfortable with the idea of owing money. Most of us have credit cards, and we don't hesitate to use them.

Suppose you purchase a few new outfits from your favourite store at a cost of $1,000 using your regular credit card, which charges you 19.5 per cent. The minimum payment on the bills that you receive is likely about 3 per cent of your total balance, meaning $30. Because interest is calculated on credit cards daily, if you make only that minimum payment, you'll barely be covering the interest! Initially, less than half of your payment will go toward the principal amount owing. If you were to stick to this approach-paying only the $30 minimum each month, it would take you about forty-nine months to pay off that initial $1,000. Even worse, the true cost of your borrowing (principal plus interest paid) would be approximately $1,457!

From Rich by 40 Copyright © 2010 by Lesley Scorgie. Published by arrangement with Key Porter Books.