Millionaire Rule #6

Pay Off Debt (except a mortgage or federal student loan):
"Compound interest is the most powerful force in the universe." This quote is often attributed to Einstein. Whether the famous physicist ever said this or not, the fact remains that the avalanche effect of compound interest produces remarkable financial sums. When a person uses credit to make purchases they are on the loosing end of compound interest; they are trying to swim against a powerful current.

One of the best ways to stay poor (or middle class) is to get onto the debt treadmill. Johnny Carson while hosting the Tonight Show once said, "Scientists have developed a powerful new weapon that destroys people but leaves buildings standing - it's called the 17% interest rate." While he was referring to the staggeringly high rates of the early 1980's on mortgages and other bank loans, rates even higher are found on most credit cards. With a credit card balance of $3,500 and a minimum payment of $50 per month it would take over 28 years to pay off the balance. The total interest paid would amount to approximately $13,500. It nearly quadruples the sticker price of a purchase if a person buys on a credit card and opts to only pay the minimum payment. Would you still buy something if you knew it would ultimately cost 4x as much on credit? Too often credit is used to buy short lived pleasures like clothes, food, or gadgets that will be long gone before you finish paying off the debt.

Obviously, getting into the habit of buying on credit it can be nearly impossible to build wealth. The same $50 per month could be saved for 5 years and you could pay cash for the $3,500 purchase. Then if the $50 per month savings were invested with an 8% return it would amount to more than $40,000 in the same time it would have taken to pay off the purchase on credit. Which would you rather do, save for 5 years, pay cash, and create $40,000 in wealth by keeping the debt payments, OR make payments for 28 years and have nothing left to show for it at the end. As you can see, credit card debt is a sucker's game.

I make two important exceptions to my rule to avoid debt. In many cases it is beneficial to take out student loans for education spending. Education has an intangible value which comes from learning and personal growth. It is an investment in yourself that will provide rewards through out your life. Education also provides a tangible value by increasing a persons employability and career prospects. Education loans also benefit from special tax treatment and generally lower interest rates that make this type of loan even more financially palatable.

I still have some caveats that need to be taken into account. First, only borrow what MUST be borrowed. Do not take out "education loans" to pay for a Spring Break vacation, bar tabs, or frequent restaurant meals. Also, do not rush off to a pricey private school to be piled up with loans when a local or state institution can serve you equally for a fraction of the cost. Second, do not borrow for a degree that you do not feel passionate about. If you do not know what you want to learn or what career you are studying for, do not take potentially useless classes. Wait until you have more life experience and are sure how education will advance your goals before borrowing to pay for it. Finally, do not borrow more than you can realistically expect to pay back. I see too many people with a passion for art or music borrow tens of thousands of dollars, while their career path will never allow them to pay back. Take out loans that are in-line with the realistic salary you can expect once you graduate. On a $30k per year salary it is a massive handicap to have $100,000 in loans. The same $100,000 is not nearly the same burden if it pays for a professional degree like law school, medical school, or masters degree in business or engineering.

My next exception to the no-debt rule is to take out a mortgage. Buying a home is often a very good wealth building method. A home will still be around long after the debt is retired. A home also goes up in value and will be worth more in the future. Everyone must have a place to live, and owning a home can sometimes greatly outweigh renting. However, it is important to recognize that this is not always the case. In many locations renting is cheaper than buying. Make sure to look at both options and choose the one that is right for you and the current market situation.

Many of the same caveats listed with student loans also apply to paying a mortgage: only borrow what MUST be borrowed, wait until you are sure you will stay in one place and are ready to buy, and do not borrow more than you can realistically expect to pay back. Other rules of thumb which apply only to home buying are: buy a house which is 2-3 times you gross income and no more, if you can't afford to have a down payment you should not buy a house, never let your house be your largest investment, and get a fixed rate mortgage. Do not allow your home purchase to control your life by eating up all of your time and money.

If a person can live their life in a way the lets the power of compound interest work for them rather than against them, they will be well on their way to wealth. Check out the rest of the Millionaire Rules to learn about other basic tenants which can guide you on your path to wealth. Be sure to subscribe to my RSS and check back regularly to follow my progress as I Aspire 2 Wealth.