Next, you cannot carry a balance on your credit card. Most personal finance books declare a crusade, a jihad even, against credit card companies and the unspeakable villains who run them. If you’ve got a problem with credit card debt, they tell you, cut ’em up, and please-oh-please, protect your children! You’d think credit cards were stealing the souls of college kids everywhere, from the way many people talk about all the tantalizing but truly terrible credit card offers that college students are deluged with on an almost daily basis. I tend to believe that most people are pretty responsible with their money. The problem is, we don’t teach people what true responsibility means. If you don’t take a long-term view or understand much about compounding, or interest rates in general, then I can see how using a credit card to pay for things you can’t afford might look pretty attractive. About half the people with credit cards pay only the monthly minimum balance, which every professional around agrees is one of the worst, albeit single most common, mistakes people make with their money. Some of you know this already, but many of you might not, and because this is a book for everyone, not just those who already have a sophisticated understanding of money, I’ll do my part in the crusade against consumer debt. But I won’t go overboard.
In our culture, debt gets a bad rap. No one wants to be in debt, and all too often we take it as a sign of personal weakness when we have to borrow money, a point that was first made brilliantly and boringly in Max Weber’s The Protestant Ethic and the Spirit of Capitalism. Maybe you read it in college. It’s a real snooze-fest with more than a tinge of racism, which is about what you would expect from a social science tome written about a century ago. The truth is, not all debt is terrible. Is a mortgage a bad thing? Is a loan to start a small business a bad thing? A loan to pay for college? Of course not, but we know that credit card debt is pretty darn awful. The difference between helpful debt and unhelpful debt is the interest rate you’re paying. But even that doesn’t tell us everything we need to know.
Obviously, the debt with the highest interest rate is the most unhelpful kind of debt. But how do we draw the line between what’s okay and what isn’t? I’m going to tell you how a money manager would approach this problem. What’s that got to do with you? Managing money for a living and trying to balance your personal finances might not seem all that similar, but the fact is that some principles of finance are universal. This is one of them. Many hedge funds borrow a tremendous amount of money to make their investments, and much of the time that borrowing can lead to some extraordinary success. As long as you’re borrowing at a rate lower than the return you’re generating, your debt is helpful. It’s that simple, for a hedge fund or a homemaker.
One problem faced by both the guys running big money in hedge funds and regular people is that interest rates don’t sit still. If the rate at which you’re borrowing money increases, that can cause huge losses for a money manager, just as it can entirely mess up your household finances. If you owe your credit card company money, it can jack up your interest rate at any time for any reason. This blindsides people, but it’s right there in the cardholder agreement. This is one reason you don’t want to maintain a balance on your credit card. You always want to pay off your credit card bill in full. I know, I know, you’ve heard this all before. I don’t care. I can’t have you getting rich on the one hand, generating a terrific return from your investments, and at the same time letting your credit card bill suck you dry at a much higher rate than you’re making on your investments.
With the exception of organized crime, no one charges higher interest rates than credit card companies. (Actually, I’m not entirely sure that’s true, as the mob isn’t very forthcoming about its lending practices. Then again, if you’ve tried to read the terms and conditions of a cardholder agreement, you might think that credit card companies could be a bit more forthcoming too.) Make no mistake, very few people can earn a better return in the stock market, or anywhere else, than the interest a credit company can charge you. A 20 percent annual percentage rate (APR) isn’t outside the norm. (The APR is the annual rate of interest you’re going to owe, including fees, if you don’t pay your monthly balance.) Sometimes the average interest rate people are paying on their credit card balance can be even higher than that. As a professional money manager, my hedge fund compounded at 24 percent a year for our investors, and we were considered a great outfit. It’s possible that you can beat that return as an individual investor, but even if you do, as long as you’ve got a balance on your credit card, the card issuer may be sucking you dry at about the same rate.
I don’t actually want to give these guys a hard time. Anyone who remembers what it was like before credit cards existed knows why. You had to get to the bank before it closed on Friday if you needed any spending money for the weekend and didn’t want to be the person holding up the line at the grocery store by writing a check. It’s also true that credit card companies lend to people who in the past never could have gotten a loan. Yes, they charge a higher interest rate, but that’s just how this game works. Lending money to people who might not be able to pay you back is a pretty risky proposition, so it’s no wonder these guys charge such high rates.
But there’s absolutely no reason why you should be filling their coffers with your money—that’s a speedy way to get poor. I’m sure there’s a temptation every time your credit card bill arrives to pay the minimum. Month to month, it doesn’t feel like you’re paying that much more by maintaining a balance, but trust me, over time it adds up. And it’s surprising, almost, how many pitfalls there are when you’re dealing with a credit card company. When you look at a cardholder agreement, what you sign to get the card, there’s a lot of fine print for a reason. They’ll give you an up-front rate, and it might look pretty attractive, but often that’s just a teaser rate, a low rate that lasts for the first few months or the first year before they spring a much higher rate on you that’s spelled out only in the fine print. What’s going on here hurts millions of people, but sometimes I have to stand back for a second, slacked-jawed in awe, and just appreciate the brilliance of what credit card lenders are doing. They make it incredibly tempting to rack up a huge balance in the first year you’re using the card with the low teaser rate, and then the trap springs, the rate increases, and you’re paying them a lot more money on the balance you accrued when the rate was low. These guys are smart, smarter than I am, no question, and even if you’re brilliant, it’s a safe assumption that your credit card company knows more about its business than you do. It will find a million and one ways to stick it to you. So don’t put yourself in a position where it can. (Incidentally, when interest rates are declining or stabilize at a low level, companies that issue credit cards are terrific investments because of the high rate of interest they charge.)
When discussing how to prevent you from becoming poor, I want to deal with credit cards first because so many people have so much trouble with credit card debt. It eats away at your potential capital at such a fierce rate that we absolutely have to take it off the table. If savings are the foundation you need to build in order to create long-term wealth, then credit card debt is like damp ground sucking the foundation down into the earth and eventually destroying your prosperity. I haven’t had to struggle to make ends meet in the era of crushing credit card debt, but every single day I speak to people who have. This stuff is ruining their lives, and they want to know why I never address this issue on my television show or in my writing. They were right, I was wrong, and now I’m here to help. If you have an unpaid balance on your credit card, paying it off should be a high priority. Should it be the highest priority? It should be second only to health insurance, which I’ll discuss later. Saving may be the first step toward getting rich, but if you have savings and credit card debt, you have to take the money you have saved and invested and use it to pay off your credit card debt. Your credit cards will devour your capital faster than you can grow it. What if that’s not enough? If you can pay off some but not all of
your credit card debt, start with the debt that has the highest interest rate. After that, you’ve got some options.
The first option is usually called snowballing. If you’ve got more than one credit card, you can always transfer your balance from one card to another. So when you don’t have enough money to pay off all of your cards at once, look over your cards and find the one with the lowest interest rate. Then find the card with the highest rate. Transfer as much of the balance as you can from the highest-rate card to the lowest one. Then pay off the lowest-rate card as fast as you possibly can, while paying at least the minimum balance for all of your other cards—more if you can afford it. Every time you pay off part of the balance on the lowest-rate card, max it out again by transferring another part of your balance from the highest-rate card. Once you’ve finished paying off the debt on your card with the highest rate, move on to the card with the next-highest-rate and do the same thing again, transferring its balance to your lowest-rate card and paying it off as quickly as you can.
You can do a variation on this same snowballing strategy by getting a new credit card. That’s right: one solution to credit card debt is more credit cards! Most card issuers will offer you low teaser rates to transfer an unpaid balance from your old card or cards to a new one that they’re issuing. It’s usually not a bad idea to take the offer. Do some research—there’s plenty of information available from card issuers on the Internet. Find the card with the lowest rate that you can transfer your balance to. But be careful. These rates are called teasers for a reason. Be sure you’re not transferring your balance to a card that will end up charging you just as much or more than you’re currently paying in interest after the teaser rate ends. It’s tempting to believe you could keep doing this, taking advantage of the teaser rate until it ends and then switching your balance to a new card with another teaser, over and over again, but as I said, these companies are smart. You might be able to do this a couple times, but after that they’ll take one look at your credit history and know exactly what you’re doing. Then they will stop giving you those teaser rates.
Another option is borrowing more money. If you have a 401(k) plan, own a home, or have what’s called a permanent or cash value life insurance policy (most people should not get this kind of life insurance—they should get term life insurance—but we’ll discuss that later), you can borrow against any of them at fairly low rates to pay off your credit card debt. All of these are called “secured loans.” A secured loan is a loan that’s backed by some form of collateral: the money in your 401(k), the value of your house, or the savings in a permanent life insurance policy. Lenders will charge you a low rate because they know that if you can’t pay them back, they’ll be able to seize these assets. Your credit card debt, on the other hand, is an unsecured loan. If you can’t pay back the credit card company, it doesn’t have a claim on any particular assets you have. You might not even have any assets. That makes lending you money a riskier proposition, and it’s one of the reasons the rates credit card companies charge are so darned high.
If you own a home or, as is usually the case, you have a mortgage, and over the years have built up some equity in your home, then you’ll want to take out a home equity loan to pay off your credit card debt before borrowing against anything else. You’ll get a much better interest rate than you’re getting from your credit card company, and usually the interest you pay on a home equity loan is tax deductible, just like the interest on a mortgage. Combined, that makes for a substantial reduction in your monthly interest payments. If you have permanent life insurance, for which you pay very high premiums but accrue savings that will be paid out in addition to insurance—and again, I must insist this is something you almost definitely should not have—you can borrow against the cash value in your policy. Here you’re actually borrowing your own money that’s locked away inside the life insurance policy. That means you’ll get to borrow at rates that are substantially lower than commercial interest rates. The lower the rate, the better the loan. That said, if you die without paying back all of the loan, they’ll deduct what’s left plus interest from the benefits that should be going to your loved ones. Because permanent life insurance policies make sense only for people who have dependents with serious disabilities that prevent them from working, this might be a big reason for you to avoid borrowing against the policy.
If you don’t own a home or have permanent life insurance, then you’ll want to borrow against your 401(k) plan, if you have one. You can’t always do this, but the vast majority of 401(k) plans have a feature that lets you borrow against as much as half of the assets in your 401(k) account, up to $50,000. If you’ve got more than $50,000 in credit card debt, you’ve got some credit line. There are both upsides and downsides to this approach. The upside is that the rate shouldn’t be more than 2 percentage points above the prime rate; that’s the best rate that banks give to customers with the very best credit. But better than that, the interest you pay on this loan goes right back into your 401(k) plan. Yes, you’re paying interest to yourself. So what’s the downside? You don’t pay taxes on your 401(k) contributions, but you do get taxed when you eventually withdraw money from your 401(k). The interest you pay on a loan from your 401(k) you will pay with after-tax money, so essentially you’ll be taxed on it twice—when you pay the loan and again when you withdraw money from your 401(k). But that’s not the worst part. You have to repay the loan within five years, and if you get fired or leave your job, you have to pay back the entire balance of your loan immediately. If you can’t afford to do that, whatever you haven’t paid back will be treated as a disbursement from your 401(k), which means you’ll be taxed on it that year as part of your income. That’s not the end. Any time you take money out of your 401(k) before you turn 59½, with a few exceptions for hardship, which includes buying your first home, that money is subject to a 10 percent excise tax, a penalty for withdrawing money from your retirement account before you are of age to retire. Still, if you think you’ve got some job security, this could be a great way to wipe out your credit card debt.
There are two more ways you can repay credit card debt: bankruptcy and the threat of bankruptcy. I’m only going to mention bankruptcy in this chapter, because unless you were on the verge of it when you picked up this book, I don’t intend for you to get anywhere near bankruptcy. But if your finances are in terrible shape and you’re loaded down with credit card debt, you can always talk to the credit card company. They really don’t want you to go bankrupt, because then it’s significantly harder for them to get your money. You’d be surprised how much clout you can actually have with a big, faceless credit card company. I know that sometimes it can seem as if you have no control over this part of your life, as if the people lending you money are the only ones who can dictate terms, but that’s not true. This situation is a variation on what the great British economist John Maynard Keynes said: “If you owe your bank a hundred pounds you have a problem. If you owe them a million pounds, they have a problem.” If you owe your credit card company money and you can’t repay it, then you both have a problem, and it’s possible to try to negotiate and come up with a mutually beneficial solution. They would much rather lower your rate than have you go bankrupt and clear all of your debts. If you call your credit card company, explain that you’re in a dire financial situation, and say the word “bankruptcy,” believe me, they’ll listen to you. Credit card companies are either owned by other public companies or are individually traded, like Capital One. All that Wall Street cares about when it comes to credit card companies, or any other financial business, is whether they’re going to get paid back for their loans. When people file for bankruptcy and stiff the credit card companies, that’s bad for their earnings. Any increase in bankruptcy filings will kill a credit card company’s stock, but people who are in trouble don’t know that. If you have a lot of credit card debt, you have an advantage. No credit card issuer wants its stock to go down, just as you don’t want any of the stocks you ow
n to go down. Use this to your advantage when you negotiate with your credit card company.
Remember, we’re doing all this because credit card debt is the enemy of financial security. It’s not just a threat to your wealth, it’s a threat to your solvency. You can’t get rich or stay rich if you have a lot of high-interest debt eating away at your finances like an economic cancer. Yes, the comparison makes sense. Just like cancer, credit card debt can metastasize, hurting your credit score (something I’ll discuss in more depth when I tell you about home ownership), making it difficult, if not impossible or prohibitively expensive, to borrow money for a house or a car. And just like cancer, once you get rid of your credit card debt, there’s a high probability that it won’t stay in remission. As long as you’re used to piling up large balances on your credit cards, it’s going to be hard to quit cold turkey. Even a healthy fear of destitution might not be enough to break the habit. And remember, the whole point is not to go broke.
The usual solution the professionals offer is that you have to build a budget. I agree, but if that were enough, people wouldn’t have so much credit card debt, would they? Fear isn’t enough, either. I’ve said it before: I’m not one of those curmudgeons who thinks that we’ve all got a problem with personal responsibility and controlling our spending, but we do have a problem with how we think about money, especially spending it. It’s not that our spending is out of control, although for some it is. It’s not that we’re addicted to buying the nicest and newest expensive products that we absolutely must have. No, our problem with spending can be summed up in one sentence: “I deserve to treat myself.”
Jim Cramer's Stay Mad for Life Page 4
