The tyranny of small debts, compounded

The simple but hard to follow rule is this: Only borrow money to buy things that go up in value.

In the old days, that meant a house and a college education, because you’d probably earn enough from either to pay back the debt, with interest. Today, housing is unpredictable and many forms of student debt are crushing (and the yield on the most expensive forms of education isn’t as high as it might be).

You can justify borrowing money to buy a car if the car enables you to make enough money to pay the debt back… But medallion cab owners in New York have recently learned that there are few sure things.

The deal with credit card debt, though is simply terrible. The credit card companies pay 2% on their interest-bearing accounts, but charge around NINE times that on the debt that some people carry–that’s a huge gap. It’s a lousy deal you should avoid if you possibly can, regardless of how unfair the economy is.

Lately, there’s been a lot of handwringing about the long-term impact of a daily treat like a cup of coffee. The Times got this completely wrong yesterday, pushing people deeper into a trap that they should run away from. And the Washington Post points out that the number of people getting a loan for their wedding is skyrocketing. This is a problem. Here’s a simple way to see why:

You can make a copy of the spreadsheet I built (hit MAKE A COPY or download) and then play with the numbers yourself.

The sad news is that the best you can do within an industrial system that makes it harder and harder to catch up through effort is to begin by avoiding debt. It turns out that paying interest on interest is a long-term trap.

The real win is to borrow money to embrace high-yield education, and then borrow money if you need it to build an asset, a business that creates value for you and the people you serve.

The system is not fair, and it’s rigged against those that get compounded.

Don’t get compounded if you can avoid it.