Some might argue that you’re only $200,000 in debt. However, when you look at the payments you’ve committed yourself to making over the years, you’re actually promising to make payments totaling $364,813.20.

Thus, I’d argue that your actual debt is $364,813.20, even though you actually only received $200,000 in cash out of it.

It’s kind of a scary way to think about it, isn’t it? You get similar scary pictures when you look at the federal budget and examine the pledges we’ve made for future Social Security payments. If we’ve promised to pay it, it’s reasonable to include it as part of our indebtedness.

In fact, I’ve actually moved to calculating my net worth in this way. This number reflects the payments I’m obligated to make in the future. Yes, if I were to liquidate all of my possessions, I could reduce that number, but it’s not realistic to think that I’m going to liquidate my possessions to pay off a mortgage. If you think liquidation is a reasonable assumption, then by all means calculate things with just your debt total.

So, now you’re $364,813.20 in debt. You’re going to have to repay that much money over the next thirty years. You’re going to make 360 payments, one per month, of $1,013.37 each (do the math – if you multiply $1,013.37 by 360, you get $364,813.20).

Here’s the interesting part. Let’s say you add just $1 to just the first payment. This single extra dollar paid drops the entire debt by $2.83. You turned $1 into $2.83 in terms of your net worth. Not only that, you’ll also have your final payment reduced by $1 beyond the $2.83 in interest savings.

Essentially, you invest $1 now and you get it back in 30 years. Along the way it reduces your debt for you by $2.83.

Let’s say you add $100 to just the first payment. You reduce the entire debt by $283.33. You get the $100 back in 30 years and, along the way, it reduces your debt by $283.33.

Let’s say you just add $1 to each payment. You reduce the entire debt you’re going to pay by $399.16. You get your $360 back at the end of the 30 years, plus it reduces your debt by $399.16.

Every time you add a little extra to the payment, the total payment amount you’ve agreed to play goes down. Your obligations are reduced for the future. Not only that, you get the extra money you added back at the end of the debt in the form of a smaller final payment.

For me, the easiest way to keep track of this and of the impact of an extra payment is to use a sophisticated mortgage calculator like this one at Bankrate or, better yet, this Microsoft Excel template. I keep my mortgage data stored in this calculator so that I can see the impact of any extra payments I might make and so that I can see how much I really owe going forward assuming I just make the minimum payments from here on out.

Why think of things this way? For me, there are really three reasons that stand out for looking at debts this way.

One, this method makes it clear how much you’re actually obligated to pay. A $200,000 debt doesn’t mean that you’re obligated to make $200,000 in payments. It means you’re obligated to make quite a lot more.

Two, it’s very clear how much of a positive impact early debt payments can make on your future obligations. The impact is large. Thanks to calculating things in this way, one can really see the big impact extra debt payments make to one’s future obligations.

Three, it lets you see how powerfully debt repayment compares to investing. Without using this method, early debt repayment doesn’t have a powerful impact on your financial bottom line. In fact, it has no impact for the time being – it only shows up very gradually as future payments begin to take advantage of the lowered principal and less of your payments go toward interest. An investment, on the other hand, can quickly begin showing returns that directly show up on your balance sheet.

If you do use this method, though, you can quickly see the long-term impact of an extra debt repayment on your bottom line. Your obligations are immediately lowered by that extra payment, which lets you breathe easier.

To me, knowing my total obligation instead of my total debt feels like a more financially honest approach. It’s the same approach many of us are demanding from our government, so why not apply it to ourselves?

On Facebook, Tyler wanted to know, “Should I stop my retirement contributions while i pay back my college loans? I am 23 and my employer will match up to 5% of my contribution. Should i continue? or hold off until my loans are paid?”

The challenge with any question like this is that it relies so much on future events. What will the stock market do over the next thirty or forty years? That’s unknown. What path will Tyler’s life take over the next ten years or so? That’s unknown as well. Both of these factor enormously into answering the question above.

The best thing we can do is follow some reasonable approximations and rules of thumb for future investment growth while also striving to give Tyler as much freedom as possible in the coming years.

The Ghost of Investing Future
In order to get an estimate of how much someone should be investing for retirement, you have to come up with a few basic assumptions.

When will the person retire? This lets us know how many years of investing we’ll be able to account for. I’ll asume that Tyler will retire at 75, giving us 52 (!) years to work with.

How much of an annual raise can we assume? I usually just match this at the same rate as inflation. Speaking of inflation…

How much inflation should we assume? I usually peg this at 3%, which is pretty sound based on the economy of the last twenty five years.

How much of an annual return on stocks can we assume? Warren Buffett projects a 7% annual return over the long haul in the American stock market, so I’ll use that number.

Do you see how tenuous all of these calculations are? When you estimate retirement savings, you’re making a lot of guesses for the future.

What you’re going to shoot for is an amount high enough so that the person’s annual expenses equal 4% of the total savings at the time of retirement.

I ran the numbers, assuming that Tyler is able to live on about 75% of his salary each year. My calculations showed that Tyler should be saving somewhere between 9% and 10% of his annual income for retirement, so we’ll use 10%.

10% is an excellent thumbnail to use. In this case, Tyler has the advantage of a long period until retirement, but I’m also using some pretty conservative returns on his investments for my calculations.

Tyler’s Choice Today
In order to make it to a healthy retirement, Tyler needs to be saving 10% of his annual income starting today. He can choose to delay it a few years, but then he’ll be locking down 11% or 12% or more to make it to his goals. He’s a lot better off locking things down at 10% starting today.

Tyler’s employer will match up to 5% of his contribution, so if Tyler contributes just 5% of his salary today, he’ll be on pace for what he needs for retirement. This is exactly what I would recommend that Tyler does.

Once that’s taken care of, he should throw every dime that he can at his debts. It is far easier to live a little lean now when you’re single and aren’t weighted down with responsibilities than to live lean later on when you’re burdened with career and personal requirements.

Should Debts Ever Delay Retirement Contributions?
This is a tricky one to answer. Quite often, people eschew retirement savings in order to pay off debts because they don’t want to make lifestyle changes. This is a giant mistake. If you find that you’re in a situation where you can’t make your minimum debt payments, a small retirement contribution, and live your current lifestyle all at once, changes need to be made with regards to your lifestyle first and foremost.

If you are in a situation where further lifestyle changes genuinely are not possible – meaning you have no cable or satellite bill, no cell phone, no new or nearly-new car, no living quarters larger than you need, etc. – then you should take care of your high-interest debts before renewing your retirement savings. Of course, this does need to be coupled with an emergency fund and a commitment to avoid debt in the future, because without that, this is all a moot point.

Personal finance almost always comes back to impulse control, and this is no different. If you can’t control your impulses and desires when it comes to spending money, financial success will almost always be elusive in your life. You won’t get ahead if you can’t control yourself.

The reason is simple. It’s all about the cash flow.

Let’s start off with the basics and explain what cash flow is. Cash flow refers to the amount of income you take in minus the required bills you have to pay. Ideally, you have money left over at the end of this process, and the more cash you have left over, the better. That cash can be saved for the future, invested, or applied to extra debt payments.

Let’s say, for example, that you’re bringing home $3,500 a month. You have a $1,000 mortgage at 6.75%, a $500 student loan payment at 3%, and another $1,000 in required bills (electricity, food, fuel, etc.). At this point, you must have $2,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $1,000 to do with what you please.

Now, let’s look at your situation if the mortgage is paid off. You still has a $500 student loan payment and another $1,000 in required bills. You must have $1,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $2,000 to do with what you please.

Because your mortgage is paid off, your monthly cash flow is far better than before. This helps you in countless ways.

Let’s say you lose your job and can only find one that gives you a 40% pay cut. At this point, you’re bringing home only $2,300 a month. In the first scenario, you have $2,500 in required bills. You’re going to have to make some major scary cuts in your life in order to make ends meet. In the second scenario, you have only $1,500 in required bills. You’ll be just fine and still have a surplus.

There are countless other examples of life changes, planned or otherwise, that can significantly alter your income. The greater the amount of required bills each month, the more difficult it is to swallow those life changes.

This is why it’s nearly always useful to improve your cash flow. Improving your cash flow improves your life options. It makes job transitions far less painful, for one. When you’re fired or “downsized,” you can take a lower paying job without pain. On the other hand, you also have a lot more flexibility with your career choices as you’re able to take a lower-paying but more career-building job. In fact, this is exactly what I did: I paid off a lot of debts, which reduced my monthly required payments and made it easier for me to live on less income, which enabled me to switch to writing The Simple Dollar full time because my cash flow was in much better shape.

The worse your cash flow situation is, the more you’re tied to your current job. It gives your boss more power and you less power because the threat of losing your job is devastating. Your job becomes more stressful by default because the always-present threat of losing that job – and the pain it would cause – is always hanging over your head. Your career options are limited, too, because you can’t deal with a reduction in pay.

In short, pinching your cash flow pinches your options.

Debt pinches your cash flow, of course. For example, getting a car loan pinches your cash flow because you’re now responsible for those payments. On the other hand, living without a car loan for a while and saving up for your next car is a much better cash flow option, as it allows you to simply pay cash for the next car, keeping your cash flow as wide as possible.

Overspending pinches your cash flow, too. If you needlessly spend a lot of money, you’ve pinched your cash flow for that month. You take money away from your savings. Thus, at a later point when you need that cash for a purchase, you’re forced to rely on debt, which forcibly pinches your cash flow.

It’s because of these things that I usually encourage people to just get rid of all of their debt. Eliminating all of your debt opens that cash flow up, making it easy to save for the future, change to a different job, or make other significant life changes that would be nearly impossible with a constant debt payment hanging around your neck.

For the longest time, I’ve been making larger than minimum payments on all of my debts. I got the idea from Suze Orman because she said that if you just make minimum payments, you’ll never get rid of debt. I have two credit cards and a student loan. Here are their interest rates and outstanding balances and minimum payments:

Credit card 1 – 19.99% interest – $3,400 balance – $57 minimum payment
Credit card 2 – 15.99% interest – $4,000 balance – $55 minimum payment
Student loan – 6.75% interest – $41,000 balance – $470 minimum payment

What I’ve been doing is putting $700 in payments towards these debts each month, but I have been spreading out the extra among the loans. This means adding $39 to each payment, giving me a payment of $96 on the first card, $94 on the second card, and $509 on the student loan.

Is this the right way to go?

Suze is both right and wrong here. She’s absolutely correct in making the point that if you make just minimum payments on a debt, you’ll find it takes decades to fully pay it off. Even worse, the longer you take to pay off a debt, the more money you pay in just interest on your debt – it’s just money lost.

However, she’s not quite right on the idea that you should make larger-than-minimum payments on all debts.

According to my back-of-the-envelope math on the three debts you named, it will take about thirty years to pay off each credit card with just minimum payments, and just under ten years to wipe out that student loan with just minimum payments. If you use your alternate plans with a bit larger payments on each debt, you save about $6,000 in total interest, pay off each credit card in about five years, and pay off the student loan one year earlier. In other words, you’ll go another five years without eliminating any of the debts.

I agree with making overpayments, but I think you should channel all extra payments to the highest interest debt. In this case, that’s the credit card with the 19.99% rate. If you make a $117 extra payment on that debt each month, you’ll pay off that debt in a year and a half. At that point, you can apply a $174 extra payment (the $117 extra payment you were making, plus the $57 you were making on that first debt that’s now eliminated) on the second credit card, paying it off in about a year and a half. You can then apply a $229 extra payment each month to that student loan (the two minimum payments, plus the $117 in extra payments) and eliminate that student loan in about seven and a half years (total).

That simple shift will get you to debt freedom one and a half years earlier than before.

This is called a debt repayment plan, and the basic idea behind it works no matter how many debts you have or what type they are. You just order the debts by interest rate, make minimum payments on all of the debts, and make the biggest extra payment you can to the debt with the highest interest rate.

You may also want to do things like negotiate with your credit card companies for a lower rate. The worst thing they can do is lock your account, which doesn’t matter a bit if you’re not using it, and you might just see a nice interest rate reduction, saving you even more money.

Just stick with contributing $700 toward your debt every month and you’ll be fine.

Now what?

Quite often today, people are bringing significant debt into relationships with them. Credit card debt. Student loan debt. Auto loan debt.

I often get emails from readers asking me how to deal with them. Should they keep these loans separate from each other? How much debt should they really share?

This was also an issue that Sarah and I struggled with when we got married. After some struggles, we eventually came to a conclusion that really makes the reality of these debts quite clear.

First of all, regardless of who actually owns the debts, they are now shared debts. When you’re married, your money effectively becomes a shared pool, whether or not you directly share that money or not. If one of you has a debt, the money to pay for that debt comes out of the shared pool. What’s left in that shared pool is smaller, reducing your opportunities as a couple to build towards other financial goals.

When we were married, for example, I had an auto loan and my wife had an auto loan. I had student loan debt, as did my wife. I had credit card debt, as did my wife.

At first, we each tried to handle our own debts. What we discovered, though, is that after covering these debts, we each had much less left over to contribute to the things we shared – rent, energy bills, food, and so forth.

Even though we were keeping our debts separate, the reality was that the consequences of those debts were shared. If the consequences are shared, then it follows that the responsibility for paying off the debts ought to be shared as well.

Which brings me to my next point: once you acknowledge the debts as essentially shared, the optimal way to get rid of those debts is to consider them all together. It should no longer matter who has the worst debt. What matters is that the worst debt is the one that you both focus on first.

When my wife and I reached this conclusion in 2006, we began to really work together to focus on all of the debts either one of us had. It didn’t matter whose name was on the credit card or on the car title. The consequences of those debts were shared, so we both benefit when any of those debts go away.

Doing all of this successfully requires complete openness. You can’t hide debts from each other. You can’t hide money from each other. You can’t hide spending splurges from each other.

Whenever you do these things, you are taking money out of that shared pool that helps you both get what you want from the future. You’re also being dishonest with your partner and, likely, you’re undermining your debt repayment plan and other financial plans for the future.

This type of dishonesty is acid to any relationship. It opens the door to other forms of dishonesty that can completey destroy a relationship.

Any relationship where things are not completely in the sunshine is a relationship that’s eventually asking for problems.

If you’re not comfortable with that openness, then your relationship needs work. This goes beyond mere finances. It’s an indication that there are trust issues in your relationship and as long as those trust issues exist, you’ve got a gigantic fault line in your relationship that can easily erupt into a earthquake.

Simply put, share your debts. Regardless of who brings them to the table, you share the consequences, so you should also share the effort of eliminating them. This can also help you to pay them off in a more optimal fashion.

What do you do?

Getting to Zero
The most vital thing that you must do in this situation is “get to zero.” What do I mean by that? Getting to zero means that you’re trimming your spending enough that your income matches your spending. If you bring home $2,000 a month, you can spend only $2,000 a month.

In order to make this number, I usually encourage people to look for big changes – single moves that can save them a bunch of money each month. Some options include eliminating cable, eliminating a telephone landline, moving into a smaller apartment, downgrading to a less-expensive car, bundling your insurance, refinancing your mortgage, or renegotiating your credit card interest rates. Almost everyone is capable of making at least one of these changes, and such a change can make a huge difference in your month-to-month spending.

Sometimes, though, making one or two big changes isn’t enough. The next step is to focus on what I call “one-off changes.”

One-Off Changes
These changes revolve around activities you can do once to either bring in a quick money spike (which you would then apply to paying off a debt) or to lower a bill for the foreseeable future.

Some options here include cleaning out your closet and selling off unwanted items, having a yard sale, selling off the contents of a collection on eBay, installing a programmable thermostat, replacing light bulbs with more energy-efficient ones, air sealing your home, and/or putting your home electronics on a more energy-efficient plug setup (with the devices set to a switch or to a “master” outlet that cuts power to the other devices when the master one isn’t in use).

The one-off options that produce a money spike can be applied toward your debts, preferably the smallest debt. Ideally, you’ll be able to pay off at least one debt very quickly, which naturally reduces your monthly bills.

The next step is the part that people think of as being “painful” when it comes to making more frugal choices.

Behavioral Changes
These changes revolve around making better choices every day. We’re constantly inundated with choices that have some financial consequence, from the moment we get up until the moment we go to bed.

Should I grab a bite at home or grab something on the road for breakfast? Should we go out with coworkers for lunch? Should I stop at a store on the way home? Should I hit Starbucks? Should I order take-out tonight? Should I go out with my friends or stay home? Should I buy this neat item from Amazon or hold onto my cash? Should I prep some stuff for tomorrow or should I just turn on the whole home entertainment system and veg out?

Each one of those situations is a choice, and each one has a financially good and a financially bad option. Quite often, it seems as though the expensive option is easier or more fun, and it seems utterly painful to give them up. It is choices like this – where you’re made to give up something you enjoy – that gives frugality a bad name for some people.

If you’re in that boat, I encourage you to not give up big swaths of stuff. That approach will leave you feeling miserable and will inevitably lead to a big backlash against making changes. If your heart is not into a big change in your life, you’ll never make that big change.

Instead, I suggest a different route. Simply focus on the choice you have at hand. Don’t make big plans about giving up Starbucks only to find yourself resenting it later. Instead, whenever you have the option to stop at Starbucks, ask yourself whether you’d rather stop or you’d rather put yourself in better financial shape. If you choose to stop today because you could really use that giant cup of sweet coffee, then go for it and don’t think twice about it. On the other hand, view it as a personal success if you decide not to stop today.

Retaining What You Save
What I usually encourage people to do is, once they’ve reached zero and are spending only what they bring in, they start directly setting aside every dollar they save to get rid of their debts.

Let’s say you’ve decided not to stop at Starbucks. At that point, literally take a $5 bill out of your pocket and put it up, or log onto your online banking service and move $5 to another account. You can also just track this with a pocket notebook with a note that says “$5 – saved by no Starbucks.”

Over time, with every good choice you make, it’ll add up. “$10 – didn’t buy that book and hit library instead.” “$12 – made dinner at home and ate leftovers for lunch.” “$8 – used coupons at the store.” “$30 – stayed home with friends instead of going to a club.”

Remember, you’re looking at individual choices here. If a choice seems too hard, don’t make it. Do not let yourself get miserable because of frugality. What I found at this stage is that most of the time, making the financially sensible choice felt really good – better than what I was giving up. I was proud of it. However, there were certainly times when I didn’t want to make that good choice, and I found that if I forced myself to do it, I ended up resenting the whole thing. Don’t fall into that trap.

The perfect is always the enemy of the good. You’re far better off making three good financial choices and two ordinary ones and feeling really good about it than making five good financial choices and resenting your life so much that you eventually backslide out of everything.

As these numbers add up, make sure you’re putting that amount to good use. It is a bad idea to make these good moves, then look at your checking account balance, think that you’re rich, then spend it all on something silly. Instead, pour that money into improving your financial situation by paying off debts, building an emergency fund, saving for a down payment, and so on. Use a debt repayment plan and make sure your dollars are going toward something powerful.

I’m visiting a lawyer next week to get started on filing for bankruptcy. I have no way to pay my debts or even make the minimum payments each month. My problem is that I simply can’t find a place online that actually explains what the different kinds of bankruptcy are and how they work in any terms I can understand. What’s Chapter 7 and Chapter 11 and Chapter 13?

I’ll attempt to explain these concepts in the clearest terms I can. Of course, when you do that, you tend to lose some details in the process, so if you want to know more about your specific situation, I suggest contacting a lawyer.

What Is Bankruptcy?
Bankruptcy simply means that you can’t pay off your debts and you’re asking the legal system for help. This event appears on your credit report and can have a negative impact on your credit score for seven years, though being diligent about following through with the plan developed in bankruptcy court means you can minimize that impact. It also means that the court system will come up with some sort of plan that works for both you and your creditors for you to pay back some portion of your debts. The exact way you do that differs depending on the type of bankruptcy.

Typically, bankruptcy is an option of last resort. It has legal costs which can add up to the thousands and a very negative long-term impact on your credit. You should only turn to this if you cannot come up with a successful debt repayment plan on your own. I suggest creating your own debt repayment plan and making a serious effort to execute it on your own before considering bankruptcy. Credit counseling can also help; in fact, it is legally mandated before you file for bankruptcy.

Chapter 11 Bankruptcy
Chapter 11 bankruptcy is usually the best option if you own a business. This form of bankruptcy typically allows a business owner to remain in control of their business while going through bankruptcy proceedings. This typically occurs if you own a business that isn’t able to pay its bills at the moment. If you do not own a business, Chapter 11 is not right for you.

Chapter 7 Bankruptcy
Chapter 7 bankruptcy is a “liquidation” bankruptcy. You can typically only use this type of bankruptcy if you have sufficient income – usually more than the median income in your state. If you qualify, what happens is that some portion of your possessions are sold and the money from selling those possessions are used to pay off your creditors.

You’re allowed to keep some of your possessions during this process depending on the specifics in your state. This usually includes your home, your clothing, minimal transportation, a few hundred dollars’ worth of personal possessions, your pensions, and a few other odds and ends. The rest of your assets are liquidated and used to pay off the creditors. At the end of this process, your creditors go away, but your credit report has a big black mark on it and you’ve lost many of your assets.

If you hear stories of people repeatedly filing for bankruptcy, that usually means they’ve adopted some form of lifestyle where they repeatedly file for Chapter 7 bankruptcy. They usually don’t accumulate assets and spend the debt money they accumulate on experiences. Then, when they file for Chapter 7, there aren’t many assets for the creditors to take.

Chapter 13 Bankruptcy
Chapter 13 bankruptcy is the most common type of bankruptcy. In this form of bankruptcy, you and your legal counsel come up with a debt repayment plan. During the process, the plan is usually adjusted a bit to match the creditor’s demands and your own ability to repay such debts. Often, these plans lower your monthly payments to the point that you can actually handle them within your income. Often, that also means that your total debt amount is lowered.

What’s the drawback? For starters, the cost usually is in the thousands – this is tacked onto the court-ordered debt repayment plan. The plan itself usually ties up almost all of your spending money for a few years as you’re paying off debts. It also damages your credit severely, as does any bankruptcy, but your successful repayments will help mitigate that damage.

Which Is Right for Me?
For most people, Chapter 13 is the best route. Chapter 7 is better if you’re a high wage earner with few assets. Chapter 11 is the one to consider if there’s a business involved.

Of course, the specifics of bankruptcy vary somewhat from state to state. If you’re considering any of these avenues, contact legal representation before you move forward and make sure you understand the specifics in your state.

Your best choice, of course, is to avoid being in a situation where you’re concerned about this in the first place. Hopefully, this advice helps those who need it – and encourages people heading in that direction to reconsider their path.

I rarely do. Taking out a loan for a car is only a good move if (a) you’re buying your first or your second car and absolutely need one today to commute to work – and even then, you should be buying a used one or (b) you have enough cash to buy the car you want but you’re offered 0% or extremely low financing, making it cost-effective to take out the loan and then sit on your investment (a pretty rare case, but one we found ourselves in recently).

We fully own both of our automobiles and don’t intend to replace either one of them for years. Of course, we’re slowly saving up for their replacements at a reasonable rate, but we’re not paying interest – interest is working in our favor.

Let’s run the math so that you can see, in real dollars, how much is saved by paying cash. You have no cash at all, but you need wheels. What do you do?

Option 1 – Buying New Now
You go to the dealership and take out a $25,000 loan on a new car. That loan is offered to you at 6% for five years, meaning you have a monthly payment of $483.32.

You drive this car for seven years. Each month, you pay $483.32 as a car payment. After five years, you own the car, but you’ve paid out $28,999.20 for the loan – $3,999.20 of that being pure interest. You then start saving $483.32 a month for your next purchase – after two years, your savings account totals $11,715.68 ($11,599.68 in savings, plus $16 in interest).

At the seven year mark, you trade in your used car for $6,000 in trade in and also make an $11,700 down payment on your next $25,000 car. You’re still borrowing $7,300 to buy the car, which means monthly payments of $141.13 over the next five years, totaling $8,467.80 – $1,167.80 of that being pure interest.

At this point, you also need to save $285 a month so that you have $25,000 in cash ready for your next car purchase at the fourteen year mark – seven years after this one. $23,940 of the savings will be cash and the rest will be interest – $1,104.64.

So, after all of this, you wind up paying out $73,006.68 over the course of these fourteen years and find yourself with a new car at the end of it.

Now, let’s look at fourteen years starting in a different fashion.

Option 2 – Buying Used Now
You go to the dealership and take out a $5,000 loan to buy a used car that will work for five years. You make monthly payments of $483.33 each month. For the first year, $430.33 of it goes towards the loan payment, while the other $53 goes into savings. For the remaining four years, the whole $483.33 goes into savings.

At the five year mark, you have just shy of $25,000 saved and the trade-in on your junker puts you over the top. New car time, paid for in cash. You then start saving for your next new car in seven years, saving $285 a month.

At the twelve year mark, you replace that car and keep saving the $285 a month. At the fifteen year mark, you have a three year old car and $10,414.67 in savings.

Over the course of all of this, you’ve actually only shelled out $63,199.80 out of your pocket for these cars.

Comparing These Two Scenarios
Here’s the real take-home message here: simply by buying a low-end used car at first in the second scenario and driving it until the owner could pay cash on a new car (at the five year mark), that owner saves $10,000. In other words, choosing to take out a loan for a new $25,000 car means that $10,000 is simply evaporating out of your wallet.

Remember that from here on out, both scenarios are going to be saving the same amount of money in their savings account to keep up with future car replacements, which essentially means that the money is a car payment.

I like to look at it this way: the owner of the second option is essentially paying himself $2,000 a year to drive a used car instead of a brand new one.

There are a few additional things to point out as well.

First, the insurance costs in the second scenario are lower as well. For those first five years, the person owns a used car which will have lower insurance costs than a new automobile.

Second, considering used cars in your buying decision can save you money. When you run the numbers on your car purchase, always include used cars, particularly ones from model years with a good reputation. Sometimes, those cars can save you significant money over the long haul through insurance savings, plus they allow you to retain some of your cash savings for your next car purchase.

Finally, having the money in the bank puts you in control. If you can buy the car in cash, you’re no longer worrying about your credit history or about whether a bank will offer you a good rate. You have your cash, you find the best deal, and you buy. Simple as that.

I’ll say this much: every time I run the long term numbers with regards to paying cash or taking out a loan for a car, I further reinforce my own plan to never again borrow a dime for a car (unless, as I mention above, I have the money in an investment that offers a better guaranteed return than the interest rate of the car loan).

I just heard an ad on the radio offering a 3.99% mortgage. That makes sense to me. Where I’m confused is when the ad then mentions a 4.22% APY immediately after that. What does it mean? What interest rate will I actually be charged?

First, let’s break down the terms.

APR, or Annual Percentage Rate, defines the interest rate that is charged to the principal of the loan. You will be charged a total of 3.99% interest on that loan over the course of a year.

APY, or Annual Percentage Yield, describes the percentage of the principal of the loan that you’ll have to pay over the course of the year.

The trick here is to understand that we’re talking about two separate and somewhat different things. An example will illustrate this difference clearly.

An Example: Quarterly Interest
Let’s say you have a loan from a bank that has 3.99% with interest that is compounded quarterly. That means that every three months, your loan is charged 1/4 of the interest for the year, which would be 3.99% divided by 4, or 0.9975% interest.

Let’s say your loan has a balance of $100,000 at the start of the year, to make the math more clear.

At the first quarter, your $100,000 loan will be charged 0.9975% interest, or $997.50. This gives your loan a new balance of $100,997.50.

At the second quarter, your loan has a balance of $100,997.50 and that balance will be charged 0.9975% interest, or $1,007.45. This gives your loan a new balance of $102,004.95.

At the third quarter, your loan has a balance of $102,004.95 and that balance will be charged 0.9975% interest, or $1,017.50. This gives your loan a new balance of $103,022.45.

At the fourth quarter, your loan has a balance of $103,022.45 and that balance will be charged 0.9975% interest, or $1,027.65. This gives your loan a new balance of $104,050.10.

Over the course of a year, your $100,000 loan turned into $104,050.10, earning $4,050.10 in interest. That’s 4.05% of the balance of the loan, which is your APY.

Thus, this loan has a 3.99% interest rate, but a 4.05% APY.

In the United States, APY is legally defined as being the rate achieved when using daily compounding. In this case, that would give you an APY of 4.07%. So, where does the rest of that 4.22% come from?

The Other Parts of a Mortgage
What the radio ad isn’t telling you is that in order to get that 3.99% interest rate, you’ll have to pay some fees and possibly a discount point or two. These are up-front costs that add to the balance of the loan.

In this specific case, the fees and points will add enough to the balance of the loan to raise the APY from 4.07% to 4.22%. In other words, the total of the fees and points will be somewhere around $165 on a $100,000 loan, or about $817 on a $500,000 loan.

These fees will be rolled into the true APR that the lender has to give you (not that nominal rate given on the radio that doesn’t include these fees), and it’s that APR that you should be paying attention to if you’re intending to live in the house for a long time.

Another point worth considering is the fact that banks are allowed to advertise interest rates as much as 0.125% lower than what they’ll actually give you. In theory, this is done to allow for market fluctuation between the time you hear the ad and the time you sign on the dotted line, but lenders often push this so that they can advertise with seemingly incredible low rates.

What’s the moral of the story? Two things.

First, shop around. Getting a mortgage is a major financial decision, one that will have an impact on you for a long time. You owe it to your finances to shop around.

Second, get the APR on paper. Remember that APR takes into account most loan costs (points, most loan fees, mortgage insurance), but doesn’t account for some other charges, like application fees, title insurance, title examination, appraisals, document prep, and so on. You’ll likely have to come up with some additional cash for those when you move forward with the loan.

No matter what, never take out a mortgage based on an advertisement. This is far too important of a decision to do it based on a radio ad. Spend the time doing your homework and shopping around first, even if your favorite radio host is recommending a particular product.

What do I do?

You can really make a compelling case for either just buying the car with cash or keeping the money in checking and using the low-interest loan. In fact, I often go back and forth on that very question, and you’ll see differing opinions on this from different personal finance folks, including answers that vary depending on the interest rate of the loan.

The issue comes down to one of personal finance philosophy: cash flow versus liquidity.

Cash flow simply means the amount of cash you have going in and coming out each month. Your income versus your expenses. The fewer expenses you have, the greater your cash flow and the easier it is to save for other goals or survive economic twists and turns.

Liquidity means that you have easy access to cash or the cash value of something. Your baseball card collection has really low liquidity. The home you’re living in has pretty low liquidity. On the other hand, the cash in your pocket is very liquid. Liquidity means you have flexibility because you have cash in hand.

The usual argument against improving your cash flow is that you have to sacrifice liquidity to get it. In other words, to buy that car, you have to sink $20,000 in cash into that car. Suddenly, you have a lot less liquidity. You have a smaller cash reserve to deal with emergencies that come your way.

The argument against liquidity is that it requires discipline to maintain it. If you had $50,000 in the bank, would you not be tempted to buy something that you wanted? If you did, you’ve lost that liquidity for something you don’t really need.

My belief is that liquidity is better if you assume that your future is full of positive opportunities. If tomorrow is going to bring opportunities to get ahead, investment opportunities, business opportunities, and the like, liquidity will open those doors for you.

On the other hand, cash flow is better if you see a future with significant risk. A future with significant risk translates into a future with reduced income or with increased expenses – in other words, a crunch on your monthly cash flow. A long illness. A job loss. A new child. An ill or dependent parent. Having collateralized debt – like a car loan or a mortgage – means that the item can be repossessed, leaving you not only with reduced cash flow, but without transportation or a roof over your head.

The problem? We can’t see the future. We do not know what’s coming in the future. Is it a future loaded with opportunity? Or is it a future with significant risk?

In the excellent book The Black Swan, the author, Nasim Nicholas Taleb, argues that we often use mental tricks to disguise the randomness of the past from ourselves, turning our very random lives into a coherent and understandable story. We often do the same thing with the future, imagining not the chaotic future we’ll likely have, but a smooth road leading to some destination.

Lately, I’ve found myself hedging my bets more and more. What if I become ill? What if my income level drops? The better my cash flow is right now, the more room I have in my cash flow to deal with these challenges.

My conclusion is this: once you have a certain size of emergency fund (I usually use two months’ of living expenses per dependent), your focus shouldn’t be on further liquidity. Your focus should be on improving your cash flow. Not only does this protect against longer-term problems, it also creates a future where you’re more able to tolerate the unexpected in your life.

In simpler terms, get an emergency fund, then shoot as hard as you can for debt freedom. That might sometimes involve additional savings (like saving up to pay cash for a replacement car), but the goal is to keep your cash flow as healthy as possible.

Coincidentally, just an hour before this article went live, I got into a Twitter discussion about this very topic.

I was at a local car dealership looking for a replacement for my truck. I only have about $8000 in savings so I knew I would have to take on some debt to buy. The dealer offered to sell me a new F150 for a good price and a 0% loan for 36 months for $589 a month car payments. This seems awesome and I am looking for any problems with it.

Over the last few months, I’ve received a few emails like Brian’s, where individuals were strongly enticed by 0% or other extreme low interest loans. Are they a good deal? Should they sign up for these loans before making a purchase?

The problem with such loans is that they don’t eliminate what I consider to be the chief problem with all debt. Yes, they have spectacular interest rates and, yes, they’re often sold as being “free money.”

However, all debt – including 0% debt – has a strong negative impact on your future cash flow. By signing up for this debt, Brian, you’re agreeing to pay $589 a month for the next thirty six months.

That means, for each of the next thirty six months, you’re going to have to come up with $589. It doesn’t matter whether money is tight that month. It doesn’t matter whether you have a job or not. None of that matters. Come up with the $589 per month or they’ll repossess your truck. Add on top of that the vehicle registration costs, the insurance costs, and the maintenance costs and you’re marking off at least $700 a month for this new vehicle each month.

That’s a pretty big responsibility to throw onto your future self. For the next three years, you’re making a commitment to $700 a month without knowing what the future may hold.

Does your future hold steady employment – or is a pink slip around the corner? Will your health be perfect in three years? In three years, will you find yourself in a situation where an F-150 doesn’t meet your needs?

Even if everything goes perfectly, there will still be months when $700 from your monthly budget will really hurt in the form of missed opportunities. Some will simply jump on board those opportunities anyway in the form of credit card debt, further mortgaging their future self.

If I’ve learned anything over the years, it’s that relying on your “future self” to do things you want right now is a quick route to failure. Our future selves are unreliable for the reasons I listed above: job loss, change of heart, illness, life changes, and so on.

Debt is always a challenging choice because it relies on that inherently unreliable “future self” to pay it off. The fewer commitments you put on your future self – and the more commitments you just take care of today – the easier you’ll find your life getting as time goes on. That means more freedom in the future, not less. That means a greater ability to go in whatever direction life leads you, not less.

I won’t say explicitly that a debt-free lifestyle is the best choice. There are times where debt is the preferred option or the only option. For example, if you’re living in a situation where the cost of renting housing is comparable to that of taking out a mortgage to purchase a home, the purchase may be the better choice.

In most situations, though, debt merely allows you to put big burdens on your future self in exchange for something you don’t need today. Brian, do you really need the shiny new 2011 F-150? Or would a used model work for now, putting less of a burden on your future self, while you save up the cash for the vehicle you really want down the road?

My husband and I are sitting on a thirty year mortgage (with twenty six years left to go). We still owe $330,000 on our home. A week ago, a very similar home to ours two blocks away sold for $220,000, so we’re under water by at least $100,000. We are thinking of just walking away from this mortgage and renting an apartment for a while until our credit clears up. What do you think?

First of all, there’s a strong personal moral element to this type of decision. Is it morally wrong to walk away from a mortgage? You’ll get strong, impassioned answers on both sides of the question. Some will argue that if you make an agreement with another entity, you’re obligated to stick to it to the best of your ability. Others will argue that banks know what they’re getting into with a mortgage and that foreclosure is a risk they accept in the agreement, so you’re just doing something within the bounds of the agreement.

As with most morality questions, I can’t tell you what to think. I personally feel walking away from your agreements when you have the capacity to fulfill them is morally wrong, akin to lying. If I were a lender, I would never lend to someone who walked away from a mortgage because I would simply view them as too big of a risk. But I’m not a mortgage lender.

Aside from that moral concern, though, is it really a good financial choice? I think it can be, but it depends on the other choices that the person makes.

First of all, walking away from a mortgage will drop your credit rating by 150 points and it will take several years to recover. Such a drop has a huge impact if your credit is good, but a much smaller impact if your credit is already bad.

What kind of impact? It will become incredibly difficult to get a car loan or another mortgage with any sort of competitive interest rate. Lenders will look at your credit score and if your score is low, they won’t offer you a prime loan (if they offer you one at all). You have to accept that you’ll either be paying for cars and homes in cash for the next several years or you’re going to be taking out loans with incredibly painful interest rates and down payments.

If you’re going to do this, your best approach is to make sure you have housing and automobiles lined out for the next several years before your credit collapses. If you’re going to get a mortgage on a second home, do it now and get a fixed rate mortgage while your credit is still good. If you’re going to rent, get your rental agreement set up now before you walk away. If you’re going to need a car in the next seven years, you might want to make the move now (unless you’ll have the cash to do it later).

Another impact is that many other services use your credit ratings to determine what to charge you and whether to do business with you. Insurance is one example of this – most insurance companies regularly do a “soft pull” of your credit and use declining credit as a reason to raise your rates. Many upscale renters will do the same thing and not rent to people with poor credit, which may limit the places where you can rent your housing. Potential employers often pull your credit (I’ve had two employers in the past do this) and use that as an element of their hiring decision, often leaning towards people with good credit over people with poor credit. These are all serious additional costs of walking into foreclosure.

In the end, I don’t think Kelli should walk away from her mortgage as a first response. She should try several other avenues first that would preserve her credit and perhaps even allow her and her family to remain in the home.

First, I’d simply talk to the lender. Explain your situation and discuss options available to you. It’s often easier for a lender to just refinance with you (sometimes even removing some of the principal) than it is to put the homes in foreclosure. Many lenders are currently focused on refinancing in this way rather than taking on more foreclosed homes, so it’s certainly an option.

Second, I’d look at the extra financial costs of what will happen if you do foreclose. Run the numbers carefully here. Include all the extra costs – a serious bump in your insurance rates, for example – and make sure you also include some estimate of the cost of the risks mentioned above – the extra cost of a new car or the challenge of finding a rental home or a new job. Those things have serious financial costs if they occur – or they might have no cost at all. A good way to appraise it is to figure out the cost if it does happen, then estimate the odds of it happening. So, if something has a cost of $100,000 and has a 40% chance of happening, it’d be a $40,000 cost.

You might be surprised to find that staying put is the best option, even if you happen to be underwater in your mortgage. If you still find that abandoning is the best option. then it becomes the moral question discussed above – and moral questions are things we all have to decide for ourselves.

In our marriage, my wife and I have agreed not to open financial statements addressed to each other. We supposedly did this so that we would be able to hide things like gift purchases from each other. Whenever we talked about our finances, we just talked about balances on accounts and didn’t worry about individual items on each other’s bills.

Over the last few years, I’d noticed more and more bills from various banks sent to my wife, but I hadn’t really thought too much about it. Yesterday, we received a call from someone from Citi who wanted to speak to my wife about her account and made it clear that the account was overdrawn and past due.

I was frustrated and worried, so I dug through the mail and found her most recent statement from Citi, which was unopened. I opened it. She had a balance of over $7,500 on it. I was just shocked, so I opened some of the other statements with her name on it that I could find. From just what I could gather in a few minutes, I found that she has $30,000 at least in credit card debt.

I put all of the statements in my bedside table for now. I don’t know what to do next. We certainly don’t have $30,000 to pay these off right now and even the minimum payments are difficult. It looks like my wife has been juggling accounts a lot because there aren’t many payments on our recent bank statements.

What do I do next? I don’t know what to do and I’m afraid of the big fight we’re going to have.

I originally included Archie’s note in my reader mailbag for this week, but I had enough to say about his situation (and I figured readers would, too) that I decided to devote a whole article to it.

First of all, this isn’t just about your discovery of the credit card debt. There has been a long history of dishonesty here – and that’s what I would call it, dishonesty. Marriage is a union based on trust and $30,000 in credit card debt is a pretty strong violation of that trust. It is going to take a lot of work to dig out of that debt.

In short, my suggestion would be that you seek marriage counseling, first and foremost. You’re in a situation now where you’ve both violated the trust in the marriage – your wife has been hiding tens of thousands of dollars in debt and you’ve opened up private correspondence to her. You have a perfectly good reason to feel that your trust has been violated and to feel upset. So does your wife.

This means your marriage has some very serious trust issues that you need to work through in order to be able to move forward successfully with a financial plan.

Why? A financial plan in a marriage only works if you can fully trust one another. You need to be able to trust that your partner is actually working towards the same goals with the same methods as you are and that if either of you run into trouble, you’ll work it out together. If you can’t trust each other, then a financial plan cannot work.

The first order of action, then, is to re-establish the trust.

If you’ve reached a point where you feel that you can trust each other again, then turn your eyes to your financial situation. View the past as water under the bridge; instead, focus on where you’re at now and how you can make your situation better from your current position. What-ifs don’t help with the here and now.

The first step to recovery would be a mutual commitment to spend less than you earn. Remember, of course, that part of your required spending is the debt repayment and also remember that you (as a couple) are spending far beyond your means (witness the $30,000 in credit card debts). Thus, this will be a lot harder than you might think. This step will take some serious work on its own. You’ll both have to face your spending head-on and make some difficult choices. But you have to get that spending under control.

Second, you need to create a debt repayment plan. A debt repayment plan is easy to set up and helps you develop an orderly method for paying your debts down.

Finally, and most importantly, the two of you need to discuss goals together. What do you want for your mutual future? Where do you see yourselves in five years or ten years or twenty years? What exactly will it take to get there? Obviously, getting control over your spending and getting rid of your debts are two big steps, but those are just two steps. You need to work together to figure out what comes next and how to get there.

Good luck.

The story ended with a very interesting line:

Ramsey says the data from his world of personal financial advice is not encouraging: Most people who consolidate their debt are back in trouble within two years.

This statistic isn’t surprising to me in the least. Zero-interest balance transfers, home equity loans, and the like can go a long way toward turning high interest debt into much more manageable low interest debt.

Most of the time, debt consolidation is used merely to give a person enough breathing room to continue their life as usual. It’s just another way to move around bills in the short term to extend the party a bit.

Of course, some of the time, debt consolidation can be a great tool for getting your house in order.

The difference between the two groups isn’t measured in dollars and cents. It’s measured in whether or not the debtor is actually committed to financial stability or if they just want an easy route to more short term stuff and long term problems.

Here’s the real truth. If you are in a situation where debt consolidation looks appealing to you, it won’t help even a little bit if you don’t get your spending under control. In fact, it’ll probably make things worse over the long run.

To get into that situation, you have to be spending more than you earn. In order to get out of the situation, you have to be spending less than you earn. If you’re not committed to making the changes it takes for that, then you’re just shifting the dirt around to dig yourself a deeper grave without the walls collapsing in on you. You’re reducing the interest rate on some of your debt, which gives you enough monthly cash flow to start racking up more debt, which is completely in accordance with your lifestyle.

Before you consider consolidation, get your spending under control. If you can’t go more than a paycheck or two without spending more than you earn, then debt consolidation will do nothing more than make the long term problem worse for you (simply because it enables you to get into even more debt).

The key is to get your spending under control, not finding a great debt consolidation program. Using debt consolidation as a means to extend your overspending ways is, as Dave puts it so nicely, an “orbital of stupid.”

This is not an oversight. Usually, it just makes a situation needlessly more complicated and takes the “simple” out of The Simple Dollar.

As is often the case, astute readers email me about this. John, for instance:

Your advice about ordering debts is really way out of line. You should pay off your home mortgage last so you can take advantage of the tax deduction.

Yes, tax deductions can be useful in some situations. Most of the time, though, they’re not much of a help and if you overvalue them, they’ll end up costing you in the long run.

First of all, most people don’t do deductions at all. 70% of tax filers simply use 1040EZ or 1040A for their tax returns, which means that they’re simply taking the standard deduction on their taxes.

If you’re doing that – and 70% of you are – then you’re not claiming a tax deduction for your mortgage or for a lot of other things. The tax implications of whether to pay your mortgage off first or another debt off first means nothing at all.

Beyond that, some of the 30% who do file the full 1040 do so for self-employment reasons and still claim the standard deduction, putting them in that group that is unaffected by deductions.

In a nutshell, if you take the standard deduction, you’re not counting your home mortgage as a deduction, and most Americans are taking the standard deduction.

Second, even if you do claim the deduction, it’s not as enormous as it’s often made out to be. Let’s look at the projected income tax brackets for 2010 and also assume that we’re talking about the average American family, bringing in $66,000 this year with two adults and two children in the household.

This income level puts that family in the 15% tax bracket. This means that if the family were to file long form and itemize their deductions, they would only deduct 15% of their annual mortgage interest from their taxes. In other words, the effective interest rate on their mortgage drops by only 15% when you take this into consideration. A 6% mortgage effectively becomes a 5.1% mortgage, in other words.

But it’s even worse than that.

To actually get that full 15%, you have to actually have other itemized claims that add up to more than the standard deduction for your family. The standard deduction for that family is $11,400. So, to get the full value of that 15%, a family filing with itemized deductions has to top $11,400 in deductions before including their home mortgage at all.

Let me show you what I mean. A couple filing jointly has a standard deduction of $11,400. They have $3,000 in various deductions and $10,000 in mortgage interest, so they’re going to file long form and itemize.

In the end, though, they’re only deducting $1,600 more than they would have with the standard deduction ($13,000 vs. $11,400). Even if you’re generous and say all of that money came from the mortgage, that’s still only a small deduction. If they’re in the 15% tax bracket mentioned above, they’re only saving $240 by filing long form. That’s the equivalent of dropping their 6% mortgage rate down to only 5.856%.

Here’s the truth. For almost all families, cash flow is much more of a day-to-day concern than tax deductions. It’s much more important that you have a low monthly debt load than it is to maximize your tax saving. With a high monthly debt load, you run the risk of going into more debt because of emergencies, and even a little bit of consumer debt taken on to handle those emergencies can quickly devour your “savings” from your deductions (and a lot more).

So, unless you’re very well off and have a strong monthly income, worrying about tax deductions and their impact on your day-to-day life is a bit of a moot point. It doesn’t save you all that much even if you do everything perfectly, and if doing everything “perfectly” means having a lot of monthly debt payments, you’re introducing a lot of risk into your life for relatively little reward.

Of course, credit card and mortgage marketers prefer that you’re in the latter situation. The more debt you’re in that you can handle and keep making the payments, the better off those big banks are because they’re just sitting back and collecting the interest off of you. Thus, they’ll talk up the tax advantages of various debts as much as they can, trying to make them sound like the greatest thing in the world.

You’re far better off having a small debt load and perhaps missing a deduction or two than having a high debt load and getting those deductions. The latter situation puts your whole financial house at risk because if an emergency occurs, you’ll have a very hard time meeting the monthly bills.

If you have a strong income, and are in a situation where you’re claiming lots of deductions anyway, it does become a factor, but if you’re in that situation, you’re in a very lucky and rather small minority of the American public.

I have a single response that I always give to this type of question:

You should only co-sign a loan that you’re perfectly happy paying off yourself.

If you would be unhappy with being forced to pay for the loan yourself, then you should not be cosigning that loan.

Here’s why.

First, the reason a lender wants a cosigner on a loan is because they believe that the person they’re lending to has a high likelihood of not paying back the loan. Usually, a person that needs a co-signer is a person with poor credit or, in some cases, a person with no credit history at all. This means that either they’ve never dealt with the ins and outs of paying a loan back before or they’ve attempted it and failed to pay back their obligations.

Second, if that person who the bank has deemed untrustworthy proves the bank to be correct, you’re left holding the bag. Co-signing isn’t just a way to help a friend. It essentially means that you’re hung with the debt if the primary signer decides not to go through with actually repaying the debt.

Third, when you turn a personal relationship into a financial one, you introduce a lot of strain in the personal relationship. If they default on this loan, what will that do to your relationship? It will be very, very hard for the two of you to be as close as you once were.

These three things together make for a dangerous mix. They put your finances at significant risk without any direct benefit to you. You’re betting that someone is reliable when someone else who is not involved has looked at the evidence without emotions clouding their judgment and came to the opposite conclusion.

To put it simply, you’re saying, “Sure, I’ll take on more risk than the bank.” You know, those paragons of financial stability who were quite willing to hand out adjustable rate mortgages like candy and almost tanked the United States economy.

“But I really want to help!” This is often the reason that people use to talk themselves into such large amounts of risk. The person asking for their help is someone who they genuinely want to help and so they let their emotions cloud their judgment and sign away.

Here’s the thing: you can usually help quite a lot without signing on the dotted line.

Offer resources that you can give them. If you want to financially help someone, don’t do it in a way that puts you at risk and don’t enter into a financial arrangement with them that could damage your relationship. Instead, make it a gift. Give them some cash to buy a beater to get back and forth to work or to put a deposit on an apartment. Let them live in your spare room for a few months. If they want to pay you back, let them, but make it clear that you don’t expect repayment.

Offer intangibles. Invest your time in them by driving them to job interviews or taking them around to buy a car. Invest your contacts in them by calling someone you know who can help them get a job. Listen to what they’re talking about and going through and offer your advice and whatever else you can offer.

In other words, offer all the help you can without introducing unnecessary risk into your life. Don’t co-sign, but offer help in every other way you can.

From my perspective, there is one exception to this. I think that the intangibles related to a parent co-signing on a student loan for their freshly graduated child likely add up to more than the risk of signing such loans. In that case, a parent is often a fairly good judge of the situation and if they view the risk of co-signing in this situation as acceptable, it seems to me to simply be an extension of the risks of parenthood.

Here’s a simple MBA lesson: borrow money to buy things that go up in value. Borrow money if it improves your productivity and makes you more money. Leverage multiplies the power of your business because with leverage, every dollar you make in profit is multiplied.

That’s very different from the consumer version of this lesson: borrow money to buy things that go down in value. This is wrongheaded, short-term and irrational.

It takes discipline to forego pleasure now to avoid a lifetime of pain and fees. Many people, especially when confronted with a blizzard of debt marketing, can’t resist.

Resist. Smart people work at keeping their monthly consumer debt burden to zero. Borrow only for things that go up in value. Easy to say, hard to do. Worth it.

The general point of the article is that any time you go into debt for something that decreases in value, you’re making a bad move. This is a pretty clear take on “good debt versus bad debt” philosophy and using that perspective as a central rule of thumb helps you to make much better choices about your money.

Virtually anything you put on a credit card is bad debt. The stuff you buy with a credit card is either consumed (like food, for example) or decreases rapidly in value after you buy it (like a DVD, for example). Once you own food, you eat it and it no longer has any value. Once you own a DVD, you open the shrink wrap, turning it into a used DVD, which has much less value.

Student loan debt is (usually) good debt. Provided that you finish a degree program, student loans are usually good debts because the value of the degree you bought with that loan is much more than the face value of the loan. As we discussed yesterday, an education has such a huge positive impact on your lifetime earning potential that it blows away the value of your student loan. Of course, this requires that you take schooling seriously and complete what you start.

A car loan is bad debt. An automobile decreases in value with every mile you drive it – it will never reclaim the original price that you paid for it. Yes, it does provide transportation which can help you earn more money, but in that case, you’re talking about absolute minimal transportation – a mid-’70s Honda Civic bought for a few hundred dollars from a junkyard will get you from point A to point B.

Mortgage debt is (sometimes) good debt. A home will usually hold its value over time and perhaps increase a bit, but a home mortgage still isn’t always a good debt if you’re paying more in interest than you would be paying in rent living elsewhere. You should always strive to minimize the amount that you “lose” each month to housing, whether it’s in the form of rent or in the form of mortgage interest.

Financing any consumer purchase is bad debt. Furniture? A television? A riding lawn mower? All of these things are often bought with a financing plan – and all of them are bad things to go into debt for because they drop steeply in value as soon as you buy them.

But I need all of this stuff that depreciates! If you need a lawnmower and can’t afford it, buy a very low-end push mower and start saving for a better one. You need only to mow your yard, so get the item that covers what you need, not what you want.

If you need a car, head to the used car dealership and look at the $1,000 section. You need only to get from point A to point B, so get the car that covers this basic need, not the shiny features you want.

If you need a new couch, head down to Goodwill. You need a place to sit, but you only want something shiny and expensive from the furniture store.

I don’t begrudge anyone a nice shiny car or a great riding lawn mower or some new furniture or a flat-panel HDTV. But those things cover your wants, not your needs. Don’t go into debt for them. Cover your needs, then save up for your wants.

The most interesting thing? Once you start separating your needs from your wants, you discover that you don’t actually want a lot of that stuff too much after all. If you have a working lawn mower, after all, the desire for a replacement is quite a bit lower.

Let’s say, for example, you’re in the situation that Paul, one of my readers who wrote in recently, finds himself in. He just took out a $219,000 mortgage. His monthly payment on that mortgage is $1,300.89. Paul wants to know whether paying half of the mortgage twice a month will save him a significant amount.

The first thing he needs to do is make sure that his mortgage allows early payments – and how they work. Make a call to your lender and ask them how often interest is compounded (this needs to be daily or compounded monthly based on the average balance of the month – if it only compounds monthly, paying in advance won’t help), plus how multiple payments during a month are applied to your loan (they must be applied as soon as received for this to work). Most loans work this way, but not all.

There are two options with making early payments.

First, Paul can literally make two payments a month – say, on the fifteenth of every month and on the last day of every month. This means, over the course of a year, Paul pays the exact same amount in principle that he would otherwise pay. The only difference is that on the fifteenth of each month, he pays in half of his payment and at the end of each month, he pays in the remainder of his payment.

In my calculations in Excel, I assumed monthly compounding using the average balance of the last month. Using this method, I calculate that this method will save Paul just over two months’ worth of balance on the mortgage. He’d save $2,931.33 in interest, which would mean he would be able to skip his final two payments and make only a partial final payment.

However, a superior method of doing this would be to simply make a payment equal to half of the amount of the monthly mortgage bill every two weeks. Over the course of a year, this adds up to one extra full payment: since there are fifty two weeks in a year, you’d make 26 half payments, and thus 13 full payments.

In my calculations, I again assumed monthly compounding using the average balance of the last month. I calculated that this method will save Paul $41,117.09 over the course of the loan. His final, partial payment would be issued just shy of five years early.

This method falls perfectly in line with many income schedules (the federal government, for example, issues paychecks every two weeks), which means that you can just allot a certain amount from each paycheck directly toward your mortgage and then not think about it again.

For me, at least, twice-a-month payments would not provide enough benefit to be worth the management hassle of them unless it happened to line up directly with my paychecks.

On the other hand, biweekly payments – once every two weeks – do provide a lot of financial incentive to give them a shot. Add on top of that the fact that it’s directly in line with many pay schedules and that would seem to be a winner to me.

In a nutshell, simply paying twice a month doesn’t save much at all, but paying once every two weeks saves a lot. Yes, one or two fewer days per payment can save you tens of thousands at the end of the payments.

Good luck.

My husband and I have been debt free for seven years. Hooray! We cancelled all of our credit cards in 2001 and paid off our home mortgage in 2002.

A few weeks ago, our homeowners insurance premium went up substantially. I called our agent to ask why and he told me that our premium was automatically raised because our credit score was low.

I got worried and checked our credit report at annualcreditreport.com (as you suggested before) and found nothing at all on our credit report. So, I called our agent back and told him the story. He did some follow-up and found that because we didn’t have any outstanding credit of any kind on our credit report, they couldn’t verify that we were responsible payers, thus we were placed into a higher risk category.

This seems nonsensical! I am shopping around for new insurance but I wanted to know what you thought of this policy.

Obviously, on an individual level, this is nonsensical. A person with no debt at all and a long history of never having debt is the type of person that ought to be considered a great client for an insurance company. I can’t think of anything that screams “stable and reliable” than a person without any debt.

Yet, if you step back and look at the broader view of society, this policy does somewhat make sense.

First of all, the insurance company has to have standard rules and practices for setting their rates. They have to know cold the risks associated with different factors, from the color of the car to the reliability of the driver. When they know these risks, then they can calculate the exact rate to charge to simultaneously be competitive with other companies and earn a profit for themselves.

Hand in hand with that is a society that lives and thrives on personal debt. Between automobile loans, student loans, consumer loans, mortgages, and credit card debt, the vast majority of Americans possess some form of debt in their lives. Given that as a baseline, it’s reasonable to argue that a person who pays their debts in a timely fashion is more reliable – and thus less of a risk – than a person who does not.

That information is packaged up nicely in our credit reports and usually calculated down to a single number that represents how efficient we are at paying our debts – our credit score. Insurance companies will often take this score and run with it, using it as a basis for determining our premiums.

Unfortunately, a person’s credit score is higher if they have small, reasonable debts and always make their payments instead of having no debt at all.

The next question, obviously, is how can a debt-free person improve their credit score without getting into additional debt? There is no easy answer to that question.

The simplest solution is to simply use credit for the most routine of purchases – groceries, gas, and so forth – and to pay off that debt in full each and every month. One way to do this – to keep things under control – is to simply get a credit card at your preferred gas station, use that card just to fill up on gas and nothing else, and then pay off the card each month. So, for example, you might have a BP card, and you would only use that card at BP.

A second option would be to stop by your local credit union and talk to a loan officer. They may be able to develop some form of no-risk personal loan for you based on using some of the assets you have as collateral. You then just leave the money at the credit union in an account and have all payments for your loan deducted from that account. If you have such assets, the actual cost of this would be minimal.

Yes, society has stacked the deck a bit against people with no debt, as there are many financial incentives to carry debt. With a little clever thinking, though, such risks can be pushed back.

I was wondering if you could comment on the debt reduction/elimination ads I keep seeing on tv. Are these companies reputable? Are they doing anything that I can’t do myself? I would hate to pay a huge fee for something I could do myself. I would really like to reduce our debt load so I can free up more funds in our budget every month for, say, groceries. Advice?

The first and most important thing to note is that not all debt reduction and elimination programs are the same. Although they’re often collected under the same grouping, these programs tend to provide an array of services.

Unfortunately, all of the services provided are either dangerous or easily replaced by free materials.

One common service provided is education inhow to pay off debt. They explain, in great detail, how to create your own debt repayment plan and stick to it. They provide workbooks and other information to make the process as painless as possible.

The catch here is that you’re paying a lot for materials that can be found at the library or online for free or even at your local bookstore for a much lower price. If this is what you need, start off by checking The Total Money Makeover out of the library.

Another common service provided is direct management of your debts. Instead of teaching you how to make a debt repayment plan, they essentially take charge of all of your debts, do it for you, and provide you with a single monthly bill.

The catch here is that the fee for their service is often very high, usually running into the thousands of dollars. Considering that a person can make up such a debt repayment plan themselves for free, this is a pricey service. There can be some merit here, though, if a person simply wants an “enforcer” or a “coach” to help them do it.

A third common practice is renegotiation of debts. This is often the tactic used by programs that promise very rapid elimination of your debt. They’ll negotiate your debt for you, often functioning as a debt collection agency themselves, then you pay them a lower, negotiated amount.

The catch here is that this functions as a nuclear bomb on your credit report. Your credit score will be in the trash for years if you take this approach. The actual amount you have to pay for this debt is less, but any debts you take out in the next seven years – or any insurance you take out – will cost you more, and any applications you make where your credit report is used as a factor will not reflect well on you.

In short, all of these plans do what they advertise, but they often cost far more than they’re worth.

The key thing to remember is this: no debt reduction or elimination plan is worth anything if it’s not paired with a sincere, long-term change in your own spending. If you’re merely using these services to give yourself some breathing room without changing your spending behaviors into a more frugal spend-less-than-you-earn attitude, it’s just a matter of time before you’re back in the same boat again – and often in worse shape if you’re back in this boat with poor credit.

On the other hand, if you first get your personal spending habits into shape and truly go forward with a “spend less than you earn” mindset, you can handle the debt repayment plan yourself. They’re easy to set up, won’t destroy your credit, and don’t cost an arm and a leg, either.

Good luck.