“Buying on the installment plan makes the months shorter and the years longer.” Most of us would agree with this. After all, debt is a trap, isn’t it?
However, not all of it.
Since childhood, we have been taught that debt is bad and that one should make sure that they deal with it carefully without falling into situations that can put them and their family in extreme distress. While most of these advices about debt make sense, you need to keep in mind that not all of your debt is bad. There’s something called good debt too.
What is good debt?
In simple words, good debt is what increases your net worth or has future value. Good debt is debt that is used to acquire income-generating assets like a business loan, home loan, education loan, etc.
Good debt lets you manage your finances effectively, helping you leverage your wealth. It helps you acquire assets that can be used during unforeseen emergencies. In a way, it also provides security during unexpected events.
Business loans: A business loan taken by you or your family is essentially good debt as it is used to start a business venture that can prove an investment in future and potentially become an asset that can grow in value if managed well.
Home loan: A home loan, again, is considered good debt as it is used to buy a house that would appreciate in value and help build wealth over a period of time. While you repay home loan for a long period, the value of your house also simultaneously appreciates over the course of time. Besides, you can also earn rent on it, meaning, it can more than pay for itself and get you profit. Moreover, it comes with tax benefits, therefore, justifying why real estate is the go-to investment option for many.
Education loan: This kind of loan is used to finance education which can bring a lot of career opportunities that could mean good income. Some student loans also have lower interest rates than others and have tax benefits. However, a student loan should be handled carefully as it can become bad debt if not paid back responsibly and on time.
What is bad debt?
Bad debt is exactly the opposite. Bad debt is what gives you a tough time. It refers to debt incurred to finance liabilities that are not likely to generate any income or have any future value. These expenses are heavy on your pocket and don’t give you any returns. Credit card outstanding, car loans, personal loans for discretionary spending, luxury items or depreciating assets are all considered as bad debt.
When not handled carefully, bad debt can put you in unpleasant situations as it only increases liabilities for you if not repaid on time.
Credit card: Most of us have this debt. This is essentially because interest rates on credit cards are extremely high and if thing go out of hand, it can take a while before you sort them out. This is why it is advisable to use credit card responsibly by making payments on time and not falling for “minimum payment” option.
Car loans: Auto loans are largely bad debt considering vehicles are depreciating assets. Some car loans also carry high interest rates. However, depending on circumstances, it can sometimes be considered good debt if one is using the car to get to work, in which case, it is used to generate income.
Personal loans: Personal loans used to pay another debt or to buy depreciating luxury items or for discretionary spending are considered bad debt as they only increase liability without adding to income or generating returns and can set you off track.
Some of money lending mobile applications offer personal loans up to ₹5 lakh
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One of the subjects we talk about most frequently on The Financial Diet, and have been hearing about at every stop of our book tour with Mint, is dealing with debt. It’s one of those things that can loom over a person like a sad, dark cloud from a ‘60s comic strip, making everything they do feel like more of a challenge (and more of an obligation), even things which the debt doesn’t technically effect. We recently heard from a viewer on our YouTube channel, who wrote in asking for advice in dealing with her massive student debt from an emotional perspective. (It weighs on her so heavily that she panicked in the middle of an otherwise-great date, overrun with the fear that he would find out that she is basically strapped with a mortgage-worth of loans and no clear way to pay it off before she’s near retirement age.) It’s one of those questions that doesn’t just remind you of how all-consuming debt can be, but shows that the real issue for most people day-to-day is the emotional side of it: the anxiety, the shame, the guilt when doing anything that feels “frivolous,” which, when you’re paying off six figures of debt, can entail essentially anything else in life.
TFD is a place where the personal side of money is always explored first, and debt feels like one of the most crucial places to speak with a much more emotionally nuanced language. Because ultimately, if we don’t look at these decisions in terms of their human meaning — if we don’t think about what each dollar means to us in terms of joy, future value, and peace of mind — the numbers on a loan statement or in our bank accounts can start to feel simultaneously overwhelming and meaningless. When I asked TFD readers for their debt stories (both living with it and repaying it), one reader wrote to me,
“I used to think of my debt in terms of ‘the biggest mistake I ever made.’ I’m one of those sad statistics: someone who got a really expensive graduate degree and basically doesn’t use it. I was on several different debt repayment plans throughout my 20s that made me feel hopeless, and because of the field I work in, I knew that there wasn’t going to be a light at the end of the tunnel in terms of having more money for basically the rest of my young adult life. I watched all these big dreams I’d always had — a house, kids, semi-frequent travel — go Slam! Slam! Slam! Like doors in the hallway of my life.
When my dad died, I went to a therapist for the first time in my life to talk about my relationship with my mother, because I wanted it to improve in his absence. We ended up talking primarily about my debt, and working with [my therapist] was the first thing that really changed my view on it. She taught me that rather than constantly beating myself up about having made that choice at 21 is pointless, and that I should look at it as an Value-Neutral Truth of my Life. I owe money, but it is not who I am. The money I spend repaying it is not money I am robbing myself of, it was never mine to begin with.”
And maybe that’s one of the most key elements of the “getting out of debt” equation: realizing that, ultimately, this money you owe is totally value-neutral. No matter your individual strategy to pay off what you owe, the endeavor can’t be an emotionally-loaded one. When I finally paid off the credit card debt that had tanked my credit at 18 years old and haunted me for several years after, I was only able to do it because I’d stopped running from it, and stopped fearing it. I’d stopped dodging the collection calls, stopped feeling an acute feeling of embarrassment any time a remotely financial subject arose, stopped thinking of all the things I was excluded from doing because of my absurdly-low credit score. I became cold about it, because ultimately, a few numbers on a sheet of paper are a cold thing. I made a conscious choice that “freedom from this debt, and a rehabilitated credit score, are more important to me than this other stuff I’d like to buy with the money I’m using to pay it off.”
But part of that becoming “neutral,” emotionally, about your debt, is realizing that the life you might be constantly (even unconsciously) reaching for — the life of someone at your income level, but without your level of debt — is something you can’t constantly be fighting against. If your taste level is somewhere you can’t afford, and your brain is perpetually convincing you that you “deserve” the things that will cost you debt repayment, you are destined to feel deprived and bitter. One of the readers who wrote about her personal repayment story put it this way,
“We poured nearly all of our expendable cash made into our debt (while setting aside some for an emergency fund). This strategy contrasted pretty heavily with all of our peers who, for instance, were enjoying $500 dinners at Alinea and purchasing extravagant handbags to celebrate their new jobs. This extends beyond just controlling spending to also adjusting our standard-of-living – our housing situation is fairly low key and costs well below our means. But hey, as of today, we are actually an entire year debt-free!
Our strategy was far from perfect and had a lot of drawbacks. We were cash-poor for that period of time in which we were working shiny new jobs, and we of course wanted to celebrate that as much as the next person. So it required real discipline on the spending front. But overall, I am really proud of our work. Now we now feel incredibly free to leave our high-paying but extremely time-intensive and, let’s be real, boring, jobs and can pursue things we find interesting.”
Making the choice to live below your means requires an active rewiring in your mind, a resolution that where you are living is not “below” anything at all, but rather exactly where you need to be to accomplish what you want (in this case, getting rid of your debt). And while that approach might feel cold or detached on its surface, it’s really just an acknowledgement of all the fraught emotion that is usually such a huge part of this process, and actively deciding to reject it. (Similarly, the hit that Lauren and I took when we left our stable, decent-paying jobs and decided to start a business required a recalibration of what we felt our lives should look like.) But getting steadfast about that shift means that you don’t have to live under its thumb in terms of guilt, shame, or resentment. Living with your parents to maximize debt repayment, or going to community college to save money (raises hand!), or making any other decision that someone might judge on its surface but which is deeply right for you is the only way to live. Because you are ultimately the person who needs to live in your life, with your bank account, and within your day-to-day budget. Debt does not have to be that dark cloud, but in order to blow it away, you have to acknowledge it for what it is, head-on. You have to look in the face of all that fraught emotion, choose to laugh at it, and choose to move forward with your life.
Chelsea is the co-founder of The Financial Diet, a media company for women who want to talk about money. She tweets.
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Ask most people this question, and they’ll break out a financial calculator, type in a bunch of numbers, and spit out a projected dollar figure for some future date.
But that’s not really what I’m getting at. Instead, I ask this question in order to challenge you to think about your Roth IRA differently, because it presents you with some unique opportunities relative to traditional retirement accounts.
In order to illustrate, let’s review the conventional wisdom of the past several decades in regard to financial planning.
The Traditional Financial Advice
Over the years, the boilerplate advice from most financial planners goes something like this:
“Year after year, invest 15% of your annual pre-tax income in a retirement account (401k, IRA, Roth IRA, 403b, or other). Then in retirement, make annual systematic withdrawals of 4% to 6%.”
This isn’t necessarily bad advice, but is it the best advice? Under such a scenario, your money will last a few decades, and hopefully you won’t outlive it.
But what if you took this advice and retired in early 2008 – right before the market tanked?
Even if you invested everything in bonds prior to retirement, are you certain inflation won’t prematurely deplete your nest egg?
Maybe it’s time to reassess your retirement plan, and a self-directed Roth IRA presents you with a unique opportunity.
Roth IRA vs. 401k & Traditional IRA
A Roth IRA holds two distinct advantages over a 401k or Traditional IRA:
The first difference is self-explanatory, but the latter is often overlooked. With a 401k or Traditional IRA, you’re required to start making annual withdrawals at age 70 ½. The amount you’re required to withdraw varies depending on your life expectancy.
But what if you don’t need to make withdrawals? Or what if you don’t need to withdraw as much as the IRS requires?
It doesn’t matter. You’re still forced to make withdrawals.
In order to determine how much you must withdraw after age 70 ½, divide your account balance as of December 31st of the previous year by the number associated with your age in the IRS Life Expectancy Tables.
For instance, at age 71 that number is 16.3 – which translates into a 6.13% minimum withdrawal.
At age 72, it’s 15.5 – which equals a 6.45% minimum withdrawal.
By age 80, you’re looking at a number of 10.2, which means a minimum 9.8% withdrawal – regardless of whether or not you need or want to withdraw your money!
These forced withdrawals eat away at your principal, especially if (when) the market experiences a major downturn.
And if you think investing in fixed income investments will protect you from market volatility, know that one trade-off is you won’t benefit from the historical inflation-beating returns of the stock market.
At this point, the true value of your Roth IRA becomes apparent. Why? Because it allows you to invest for cash flow instead of asset appreciation.
Cash Flow vs. Asset Appreciation
When it comes time to withdraw your funds, which is a more consistent and reliable source of cash in your pocket – stock prices or dividends?
Looking at the past 40 years of historical S&P 500 returns (1972 to 2011), the index posted an annual return of 11.58% with 25 of those years experiencing a gain of greater than 6%, while 15 were below 6%.
Over the same time period, dividends increased year over year in 37 of the 40 years, posting an average annual increase of 10.89%.
Conventional wisdom advises us to invest for capital appreciation and then sell off our assets in retirement. But why sell off your assets? If you do, eventually you won’t have any assets left.
Fortunately, an alternative option does exist. It’s called “investing for cash flow”.
Unlike traditional retirement accounts, your Roth IRA allows you to invest solely for cash flow, withdrawing only (if you so choose) the annual cash generated by your dividends. Meanwhile, your principal remains intact, decreasing the likelihood you’ll run out of money in retirement. Even if the market declines 40%, shrinking your principal, you’re focused on dividends only – and you can withdraw these tax-free! In the meantime, market fluctuations don’t matter. Why?
Because if you invest for cash flow, you don’t care what the overall market does. What matters is the cash dividend, not the current price of stocks. And dividends are remarkably consistent and resilient from year to year.
Let’s take 2009 as an example. That’s the most recent of only 3 years in the past 40 in which the dividend payout on the S&P 500 decreased year over year. That year, dividends declined 20% from the previous year. But that stands in stark contrast to a 37% decline for the overall stock index.
So if you had a $1 million retirement account with a 3% dividend yield, you would go from $30,000 per year in dividends to $24,000. But if you relied on stock price appreciation for retirement, your $1 million balance declined to $630,000, and you would have to withdraw a minimum 6.13% from your account. This would deplete your principal by $14,619 (or 2.3%) when accounting for the $24,000 in dividends. And this is under a best case scenario. As you age, your required annual minimum withdrawal will increase in both percentage and dollar terms.
Conclusion
Roth IRA calculators give you one option for projecting the future value of your Roth IRA. But more important than the size of your retirement nest egg when you quit working is how you plan to utilize it.
Instead of selling off your assets during retirement, consider leaving the principal untouched for the rest of your life and living off of the dividends.
Then you can withdraw those dividends tax-free each year while your principal continues to grow (unlike your 401k or Traditional IRA which force you to start making withdrawals at age 70 ½).
Meanwhile, your dividends grow at an annual pace faster than inflation – meaning your standard of living increases and you don’t have to worry about outliving your money. And that’s the true future value of your Roth IRA!
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Personal finance and investing gurus are fond of an old Chinese proverb: “The best time to plant a tree was 20 years ago. The second best time is now.” Chances are you’ve heard it before.
It’s a profound quote, and trees are a great metaphor for growing your investment portfolio. If you water the tree daily – and have patience – you can expect to reap the rewards in due time. Whether you start investing in college or after you turn 40, the important thing is planting the seed.
The problem is, this proverb actually undersells the importance of starting as soon as possible from an investing perspective.
While a tree grows to maturity at a sustained rate and only reaches a certain height, investments actually grow larger the earlier you start. If investments are trees, then the seed you planted today may grow as tall as a mighty redwood, while the one you plant in 20 years becomes a pine. In other words, the growth potential of your portfolio is directly tied to the amount of time you give it to grow.
This is thanks to something called compound interest, where the interest your account accrues is compounded on itself. Here’s everything you need to know about compound interest – how it can help you, how it can hurt you and how to maximize its benefits.
Keep reading for a comprehensive look at compounding interest, or skip to the section you’d like to learn more about using the navigation links below.
What is Compound Interest?
There are two ways to accrue interest: simple and compound. Simple interest is when you earn interest only on the principal. So, if you have $1,000 invested at 5% interest, you’ll earn $50 every year.
Compound interest is earned on the principal and the interest in your account. Let’s look at a hypothetical example. Pretend you have $5,000 in a retirement account, earning 7% interest each year. The first year that your account is open, you earn $350 in interest, which brings your total to $5,350. The following year, interest is calculated based on that $5,350 total, not the original $5,000. You earn $374 in interest and now have a total of $5,724.
Even if you never deposit anything but the original $5,000, you’ll have $38,061.28 in 30 years. That’s a $33,061.28 profit.
Compound interest rewards people who invest over long periods of time, not necessarily those who can afford to invest the most. It’s specifically helpful for young people who start investing early.
A 25-year-old who invests $200 a month with 7% interest will have $226,705.89 in 30 years. If they wait 10 years to start investing, they’ll have to more than double their savings rate to reach the same total.
Use our compound interest calculator to see how much of a difference it can make.
Pros and Cons of Compound Interest
Compound interest is your best friend when you’re investing or saving for a long-term goal, but it’s your worst enemy if you have debt that’s not being paid off.
Here’s an example: A borrower with $30,000 in student loans defers their loans for a year while they look for a job. During that year, interest continues to accrue on those loans. Once they’re ready to resume making payments, they discover their $30,000 balance has grown to $45,000 because of compound interest.
To slow down the negative effects of compound interest, you should pay off your debt as quickly as possible. You can also refinance your loans to a lower interest rate. When you borrow money, compounding interest works against you and benefits the lenders. The interest rate a lender charges is the trade-off for taking on the risk of lending money and giving out loans. However, it makes it very important for you, the borrower, to pay off your loans on time and keep tabs on your interest rate.
If you have credit card debt, you may want to consider transferring your balance to a card with 0% APR to avoid interest while you pay off the balance. Otherwise, you’ll accrue interest that makes it more expensive for you to carry debt month to month.
Calculating Compound Interest
To calculate compound interest, you’ll need to use the formula below:
Compound Interest = Amount of Principle and Interest in Future (or Future Value) less Present Value
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
P = principal, i = nominal annual interest rate in percentage, and n = number of compounding terms.
Compound Interest Investments
Some banks only calculate interest on a monthly basis, while others do it every day. More frequent compounding is better when you’re trying to maximize interest, so find out how frequently your bank calculates interest. You might have to call or poke around the fine print to determine their compounding schedule.
Next, find the highest interest rates possible while also minimizing risk. If you have a savings account with $10,000, choose a high-yield savings account. Aim for 2% interest or higher. A $5,000 savings account with 2% interest will be worth $7,459.04 in 20 years, but only worth $5,204.05 in a savings account with .2% interest. Using an investment calculator can give you a better idea of how interest will impact your return.
Compounding interest investment accounts can help both grow your money and secure your future. But it’s important to start early. And before you start investing in stocks, it’s important not to get ahead of yourself. Do your research and familiarize yourself with different investment options. Make sure you’re only investing money after you’ve topped off your emergency fund. It’s also important to ensure that you’re current on all your loan payments. Otherwise, any investment gains might be negated by snowballing debts.
If you’re saving for retirement, invest in low-fee index funds. Fees of 1% or more will drag down your profit and cut into your compound interest. Index funds will follow the market’s course and provide a solid rate of return. Avoid investing in individual stocks, as their volatility can be problematic.
Compound interest works best if you start saving as soon as possible, even if it’s just $25 a month. A 22-year-old who saves $25 a month at 7% interest for five years will have $1,795.80. When she gets a raise after those five years and can afford to put away $100 a month, she’ll have $294,213.07 when she retires at age 67. If she hadn’t started investing until after her raise, she’d only have $264,689.70.
Even though she only contributed $1,500 during those first five years, her portfolio is worth nearly $30,000 more. For most people, that’s enough to retire a full year earlier, and all it cost her was a monthly contribution of $25. Even someone earning an entry-level salary can afford that.
The same principle applies to debt. Even if you defer your student loans, keep making payments on them as much as you can afford to. Taking time off will only delay your debt payoff and increase how much you pay in interest.
Always compare rates before taking out a loan and get at least three quotes. Each percentage point matters when you’re borrowing money, especially for long-term debt like a mortgage. You can also limit compound interest by borrowing money for as little time as possible.
A 30-year $200,000 mortgage at 4.85% interest will cost $379,940 in total. A borrower who takes out the same loan for 15 years will only pay $269,910. That’s a difference of $110,000, which is more than half the total mortgage principal.
Takeaways: The Power of Compounding Interest and Growing Your Wealth
Compound interest can help you grow your wealth and secure a more stable financial future. Even if you can’t afford a large principal or large ongoing additions to your investment, you can still extract value from small investments with compounding interest. The key is to start as early as possible and do adequate research to ensure that you’re making investment decisions that make sense with your overall financial goals and situation. With these tips, you’ll be on your way to stabilizing your financial foundation and making your money work for you.
For more information on compounding interest, you can check out dolv.gov for more resources.
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Zina Kumok is a freelance writer specializing in personal finance. A former reporter, she has covered murder trials, the Final Four and everything in between. She has been featured in Lifehacker, DailyWorth and Time. Read about how she paid off $28,000 worth of student loans in three years at Conscious Coins. More from Zina Kumok
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