We have a problem
If you haven’t noticed, Americans love debt. The average household has around $130,000 in total debt, including $50,000 in student loan debt, nearly $30,000 in auto loans, and $16,000 in credit card debt.
With an average credit card interest rate of 15%, that would be $2,400 in interest per year. With a student loan interest rate of 6.8%, that would be $3,500 in interest, and with a 3% auto loan, that would be nearly $1000 in interest. In total, that’s almost $7,000 in interest per year. Sounds like a great way to bury yourself in a hole that you can never escape from. Goodbye freedom.
Luckily, there’s a solution
The way out of this debt nightmare is to only buy stuff that you can afford. How do you know if you can afford it? Simple. If you have the cash to buy it, then you can afford it. If you don’t have the cash, then you can’t. Here are the details.
Save for your freedom first
If you want to earn your freedom, remember that you can’t actually spend everything in your paycheck. Depending upon how fast you want to earn your freedom, you should save anywhere from 20-50%. I recommend 50%, but you may choose to be less aggressive.
When you get paid, before you do anything else, you need to take that 50% and either pay off your existing debt, establish an emergency fund, or save for retirement. Check out Don’t Put Your Shoes on Before Your Socks for a blueprint on how to prioritize these goals.
Do whatever you want with the rest
If you’ve saved your 50%, then you can do whatever you want with the rest. Of course, you need to have some sort of plan, otherwise known as a budget. You can’t just blow all your money on bikes and not pay rent. But there are otherwise no restrictions on this money. You can spend it all and feel good about it.
The trick, of course, is that this is all the money you get. If you run out before your next paycheck, then you can’t spend anything. You should have an emergency fund for unexpected large expenses, but in general if the money isn’t in your checking account, you can’t buy anything else. Treat your credit card like a debit card, not a free money machine.
What about large purchases?
The same thing goes for big purchase items. If you can’t buy your car with cash in your checking account, then you can’t afford it. If you can’t immediately write a check for that $10,000 heli-skiing trip, then you can’t afford it. Don’t even think about a purchase plan on the new iPhone X. If you can’t give them ten $100 bills, then you can’t afford it.
Are there exceptions?
If I was completely consistent here, I’d also tell you to buy your house with cash and your education with cash. While those are certainly laudable goals, a house and an education are not depreciating consumer assets.
Both an education and a house can pay future dividends. Your education pays you dividends in the form of a marketable skill that brings in a paycheck, and a house owned free and clear pays you dividends in the form of free rent.
In that sense, a house and an education could be considered investments that may be justifiable to finance. Just make sure that you keep your housing and educational costs as low as possible. Do you really need a $150,000 bachelor’s degree in computer science from Stanford when a $50,000 degree from your state school will give you the same skills? Do you really need a $500,000 house when a $200,000 house will keep you safe and dry? Choose carefully.
It’s really simple
It doesn’t matter if you really want to buy something. If you don’t have the money, you can’t afford it. Don’t even think about pulling out that credit card unless you can immediately pay it off with what’s in your checking account. Remember, you need to learn to suffer. Maybe not forever, but at least until you earn your freedom.