Everybody Lives Within Their Means

For most of us, no matter what we owe, we live within our financial means. We do this in one of three ways.

The First Way

In The First Way we spend less than we earn. This is a desirable position. For some it is easy; for others hard. There is no magic bullet nor secret formula (no so-called Royal Road to Geometry) to make what is hard, easy. But there is, ultimately, a simple tip: if you can't afford it, don't buy it. This applies to houses, cars, and pizza. By thinking about credit and debt in terms of Good Debt (funding an appreciating asset), Neutral Debt (funding an enabling necessity) and Bad Debt (everything else), we get a guideline on when to incur debt. If it isn't a strategic investment, if it isn't an enabling necessity, then use no credit levers; buy only what you can afford today.

The Second Way

In The Second Way we live within our means but with accumulated credit card and other debt. We accumulate it to a point were we are paying $500, $700, $1,000 a month or more to service consumer debt. The load is burdensome; our life is stressed. But we make it, year in, year out. Basically, we have hit a financial equilibrium—we are essentially living within our means—but doing so like the Red Queen in Alice in Wonderland: running in place just to keep up. This is not so desirable. We are "living within your means" in the sense that money In equals money Out, but with none of the security and benefits we would otherwise realize if we did this without debt.

We are exercising financial responsibility—meaning that we are not spending more than we earn. But we reap few of the benefits of a well-balanced approach. The monthly debt is burdensome; it is restrictive.

This "second way" equilibrium tends to be unstable. Things are likely get better or worse.

The Third Way

The Third Way is when things get worse. Why things get worse may have a myriad of causes: medical necessities, lost job, good decisions with bad luck, or sometimes, perhaps, just bad decisions. Unable to balance the burdening debt load, finally the creditors stop extending credit and start out-sourcing collection agencies that impose heavier and heavier demands for payment. The debt-laden "equilibrium" falters and ends in bankruptcy. We are now denied credit. We are forced into a cash economy. Everything is cash. Money In equals money Out. We are living within our means.

So all of us, in the end, live within our means. We may seek to do it earlier, beneficially, using credit as an Archimedean lever at our disposal, a tool to help us live where we buy simply what we can afford. Or we may live it as a condition forced upon us. There is no debtors' prison in the U.S., but life with burdening debt is anything but freedom.

Good Debt, Neutral Debt, and Bad Debt

There are three kinds of debt: Good, Neutral, and Bad.

Knowing how to recognize these kinds of debt can guide you in making decisions that can have a big influence on your life.

If you recognize all debt as simply good, neutral, or bad, you will have a surprisingly strong guide to making good financial decisions.

Good Debt

Good Debt is debt that is an investment; debt that allows you to gain equity in an asset. For many people, the only good debt they will ever have is a home mortgage. For some, even this may turn out to be not so good at all. To understand more about how to ensure that your home mortgage is good debt, we discuss it on this web site.

There is a difference between buying something that you think will appreciate in value—art, classic cars, stocks—and buying the same thing with borrowed money.

When you buy with cash you may make a good or a bad decision. But when you buy with borrowed money, you almost always have to pay some type of interest—a cost for accessing and using money you don’t have. This borrowed money is debt, and few things in daily life appreciate in value sufficiently to out-weigh the cost of debt.

Think about that. Virtually everything you buy on debt raises the cost of ownership beyond the point where simple resale would recover your expenses. Yet debt—actually credit—is equally essential to a modern life. So how to balance the two?

Few material things appreciate in value—most depreciate—and thus few things create opportunities for Good Debt.

Neutral Debt

Neutral Debt is debt for a depreciating asset, but one that is enabling for a broader success. For most people, a car loan is an example of Neutral Debt. The car you buy with a auto loan depreciates from the moment you buy it, yet for many the car allows you to hold a job, earn an income, take the kids to school, and otherwise engage society. Indeed, without a car, you may not be able to afford a house, so the car enables your financial success. The car depreciates in value, and the loan costs you money in interest, so you are losing on both ends—the debt itself is not Good Debt—but it is, or should be at least, worth it's cost in terms of enabling a larger prosperity.

Bad Debt

Bad Debt is everything else.

Everything else.

We strategically take on Good Debt, minimize Neutral Debt, and eliminate Bad Debt.

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