Blog | Personal Finance
How to Avoid Debt
Two simple steps to help you stay out of consumer credit card debt
Rich Dad Personal Finance Team
October 10, 2024
Summary
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Cutting up credit cards isn't the only way to avoid debt
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Always remember: there’s good debt, and there’s bad debt
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These tips will teach you how to strategically avoid bad debt
For most American families, the biggest barrier to financial freedom is the persistent rise of bad debt. The Federal Reserve Bank of New York's Center for Microeconomic Data, recently released its Quarterly Report on Household Debt and Credit. This report revealed that household debt increased by $109 billion during the second quarter of 2024. Credit card debt alone rose by $27 billion.
This debt is overwhelming many middle class families, and it's easy to see why. Credit card debt is one of the easiest traps to fall into. Applying for a new credit card takes little time, and in the moment, using a card to make purchases has little immediate consequence. It's not until you have a balance in your account at the end of the month that things start to go sideways.
A history of credit
Before credit cards, retailers offered layaway plans. Someone would go to a store, such as a furniture outlet, choose the sofa they wanted, and put it on layaway. That meant they put a little money down to hold the sofa, and every payday they’d pay a little toward the purchase. When the sofa was paid for in full, the sofa came home.
At that time, stores also offered "buy now, pay later" plans. This meant one could buy the sofa, sign a payment agreement, and take the sofa home that day.
Today, while a few stores still offer such plans or even variations of them, most people simply put their purchases on a credit card. But credit has been a part of American life even before there were credit cards.
A growth industry
There are many reasons why credit cards have grown in popularity, including these:
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Wall Street has turned debt into an asset.
Today, your friendly banker issues you a credit card. He then sells your debt to a Wall Street firm, which collects your monthly payments at high interest rates -- which is why it's an asset to them. The minute a Wall Street firm purchases your debt, your bank no longer has it on its financial statement, which then allows the bank to look for more credit card customers. That's one reason why you get so many credit card offers.
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The purchasing power of the dollar has dropped.
If you've followed these columns, you know that in 1971, President Nixon converted the U.S. dollar from money to a currency. That means the U.S. and other governments can print money faster than you can earn it -- or save it.
In terms of purchasing power, if you earned $50,000 in 1996, you would have to earn $100,000 in 2006 just to stay even. Many people aren't earning more even though prices are rising, so they make up the difference by using their credit cards for everyday purchases.
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When wages go up, so do taxes.
Because the purchasing power of the dollar has dropped, many people work harder, ask for raises, or take on extra work (or a second job) to earn more money. And when they earn more money, they move into higher tax brackets.
Today, the alternative minimum tax (AMT) -- first levied in 1970 as a tax against the rich -- is penalizing the middle class. In many ways, the AMT is a form of double taxation. Many working people are now making more money but taking home less because they pay a higher percentage of taxes.
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The cost of retirement has gone up.
It used to be that people worked for a company with a pension plan that covered them for as long as they lived. If they didn't have a pension plan, they could count on Social Security and Medicare.
That's all changed. Today, millions of workers need to be able to afford their day-to-day living as well as put enough money aside for when they can no longer work.
How to avoid bad debt
The Urban Institute, partnering with the Arizona Federal Credit Union, provided two “rules of thumb” based on 14,000 credit card users, to guide usage and help avoid bad debt. These two rules are listed below, along with some of my own tips to watch your credit card habits and avoid falling into bad debt.
But first, let's take a dive into the history of credit cards:
Don't swipe the small stuff
The Urban Institute writes: "Don't swipe the small stuff. Use cash when it's under $20."
It's amazing how quickly small purchases add up. Things like your daily coffee or a snack from the corner market cost you more than you realize. It's easy to justify all those small purchases at the time. Only $3 for a plastic water bottle? No problem! But at the end of the month, those purchases add up.
When you use physical paper money, it can help you be more aware of how much you're dolling out. It might even cause you to reconsider those small purchases when you find yourself running out of cash quickly.
So in the future, when purchasing things under $20, try using cash instead and see how your spending habits change.
Credit keeps charging
The next rule of thumb says: "Credit keeps charging. It adds approximately 20 percent to the total."
Credit card interest is always compounding, and over time it quickly adds up.
Let's say you have $100 debt and it accrues 20% interest every month. In your first month, you will be charged $20, which gets added to your original debt. The next month, you are again charged 20%, which now comes out to $24. So after only two months your debt has gone from $100 to $144.
This compounding interest works against you as you try to pay off your credit card debt. Some credit card companies even compound at a daily rate, not monthly, so being aware of how your interest grows can help you stay out of trouble.
Pay your balance
Here’s a bonus: pay your balance!
It might seem like a no brainer, but to avoid severe credit card debt, pay off your balance at the end of each month. Debt grows when you start each month owing on payments and collecting interest on debt from the month before. As they compound, you can quickly find yourself in a hole you can't get out of.
Paying off this debt is not impossible. (You can read Robert's article here about 6 ways to erase debt.) But the best defense is a good offense, so head off trouble early to avoid bad debt where you can.
Learn to live with credit cards
Clearly, cutting up credit cards won't address these economic changes or solve America's debt problem.
In the real world, credit cards are essential. It would be extremely difficult to rent a car or make hotel and airline reservations without a credit card. It would also be tough to pick up the tab at a business lunch or shop online without a credit card.
But here’s the trick: fight debt with debt.
Fighting debt with debt
If you want to solve the credit card problem, you must fight fire with fire (debt with debt). To solve the increasing needs for cash, go deeper into debt – gooddebt, not bad debt.
For example, real estate investors use debt -- which is essentially tax-free money -- to invest in real estate, which in turn increases cash flow. Not only do investors not pay taxes on their debt, they could also pay no taxes (or very little in taxes) on the income from the debt. Hence they earn more but pay less in taxes.
Obviously, in order to do this you need to know how to use debt wisely and responsibly, and must be able to find great investments that increase cash flow.
The Root of the Problem
Most financial experts will scoff at the "fight debt with debt" approach. They'll say this advice is based on flawed logic, and it may well be -- for most people. But take a step back and take a look at the world of finance. That's what financially smart people do, and it's the reason why rich people get richer.
Unfortunately, most people take bad debt and turn it into horrible debt. This is especially true of poor people and people with bad credit, who have access to only the worst forms of debt and pay the highest interest rates on it.
But their problem isn't credit cards -- it's a lack of financial know-how. And at the root of that lack of knowledge is our school system and its archaic curriculum, which is out of touch with the way people really live.
Clearly, advising people to cut up their credit cards won't solve the problem of excessive credit card debt. A pair of scissors won't make anyone financially smarter, but some financial education just might.
Original publish date:
September 15, 2016