Friday, February 13, 2015

Step 3 – Avoid Debt

I mentioned earlier that avoiding debt is one of the critical steps necessary to accumulate wealth and to be able to enjoy a comfortable retirement. The reason this is so important is the opposite from why it is important to begin saving as soon as possible. When saving, the longer you save money, the more you can accumulate because interest compounds upon itself. With debt, the longer you are in debt and paying interest, the longer it takes for you to be able to save and accumulate wealth.

I'll talk a lot on this site about avoiding debt, how we got out of our non-mortgage debt, and tips for paying off debt, so this post is not intended to cover everything debt related. Of the most successful investors and retirees I have worked with, one of the key similarities in their behaviors was the avoidance of debt throughout all stages of life. Sadly, many people believe that they can be in debt for their entire careers and then in the last few years before retirement pay off credit cards and car loans, and then naively assume that they will be able to retire comfortably having only one years' worth of income. Instead, what happens when you spend decades of your life in debt is that even if you are earning a decent return on your investments, your net worth growth is being pulled down by interest payments that effectively rob your retirement to satisfy your current desires.

To help illustrate the point, let's compare the long-term implications of the decisions of two recent college graduates who both start good jobs after graduation at 22 years old. Graduate 1 decides to begin saving for a rainy day and for retirement right away. Graduate 2 does what I have often seen happen and decides to buy a new car. Like most Americans, graduate 2 doesn't have $30,000 lying around, so he takes out a loan (we'll leave the topic of leasing for another time). If borrowed at 4% for 5 years, simple math will tell you that over the life of the loan, the total interest paid will be right around $3,150.

If graduate 1 simply took the amount of money graduate 2 was paying in interest and invested it, assuming an average 9% rate of return, it would grow to over $100,000 by age 65!

One new car purchase is not likely going to be the difference between being able to retire or not, but borrowing money can be addicting. Getting into the trap of always having a car payment and other debt makes it significantly more difficult to accumulate wealth. The seemingly small decision to buy a new car has much larger and longer financial implications than just the life of a loan. As the saying goes "Those who understand interest earn it. Those who don't, pay it."

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