Chris Farrell: Dumb Debt vs. Smart Debt

Last Updated Feb 2, 2010 1:05 PM EST



In his new book, The New Frugality: How to Consume Less, Save More, and Live Better, public radio's Marketplace Money economics editor Chris Farrell says understanding the difference between wise debt and foolish debt is essential today. Follow his rules for credit cards, mortgages, car loans, and student loans, so you'll borrow with your head, not over it.

The save-more-and-borrow-less mantra of the New Frugality signals a dramatic change from our past. I believe one of the key building blocks for getting your finances under control today is to borrow conservatively and wisely. My strong belief is that we should only take on debts in 2010 that offer a return over time, such as a home and a college degree.

I’ve done wise debt and I’ve done foolish debt, far too much of the latter, and not enough of the former. The difference isn’t the type of debt, but the margin of safety.

Take credit cards. A friend of mine puts everything on his credit card every month, from groceries to gas. He pays off the bill in full at the end of the month. He could pay for cash for what he puts on the card. He doesn’t because over the years he has accumulated plenty of points for cheap airfares and to stay at luxury hotels at cut-rate prices. He has always had a margin of safety — the cash on hand — and the discipline to pay the bill. He used credit cards to accomplish other goals at a cheap price. That’s a wise use of debt.

A mortgage can be foolish debt. Take the case of Seth and Joanna Goslin. In 2005, they bought a 1,200-square-foot condo in Elk Grove, Calif., for $193,000 with an no-down-payment adjustable mortgage whose rate would be fixed for the first two years, then would be adjusted afterward for the next 28 years. To lower their monthly mortgage bill, they later refinanced into a riskier mortgage — an “option” ARM, which lets borrowers choose to make payments that don’t cover the interest. “We understood that it was a risk, but we sort of just assumed it would kind of work out,” Joanna said. After real estate prices fell and Seth lost his job as a mortgage broker, the couple lost their condo in foreclosure and declared bankruptcy. Seth and Joanna didn’t have a sufficient margin of safety.

Here are my seven New Frugality rules for managing debt wisely:

Credit Cards

  • Don’t own more than one credit card, unless you need a separate card for business expenses.
  • Pay off your credit card bills in full monthly.

Mortgages

  • Put at least 20 percent down and get a plain-vanilla, low-cost, 30-year, fixed-rate mortgage.

Car Loans

  • Keep them under three years. A six-year auto loan may offer lower monthly payments, but the total cost is too steep. Buy a cheaper car. (I’m no fan of leasing, since leasing turns into a world of perpetual car payments and encourages you to buy more car than you need.)
  • Make as big a down payment as you can, to keep the monthly payments lower.
  • Be sure the loan has no prepayment penalty, so you can pay off the loan sooner if you want.

College Loans

  • If you child needs to take out a student loan, rough out the numbers so no more than 8 percent of his post-college income will go toward paying off the debt.

From The New Frugality: How to Consume Less, Save More, and Live Better by Chris Farrell. Copyright 2010 by Chris Farrell. Reprinted by permission of Bloomsbury USA.


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