FI's Enemy Number 2: Debt

Key Takeaways

• Most people think it is normal to have credit card debt, personal loans, student loans, car loans, and home loans.

• Let me tell you that paying interest on loans is one of the worst enemies of becoming financially independent!

• In general, avoid debt like hell. There are a few exceptions discussed below.

Baby Steps

• Review the annual percentage rate (APR) for all your loans, if you have any, and plan to first pay off the loan with the highest APR. That's the loan on which you pay the highest amount of interest each year.

The Whole Story

A lot of people dig a deep hole for themselves early on in their adult life by taking out student loans, car loans, and home loans. In addition, they use credit cards to buy things which they cannot afford (and which they probably don't need) and end up paying a lot of interest on unpaid balances. While broadly accepted by society, this is not a healthy financial behavior.

As a rule of thumb, simply avoid debt like hell in order to expedite your path to FI.

It is certainly good to get a college degree to get a high paying job later on. However, minimize or avoid student loans. Instead, apply for scholarships, get a student job, or even consider studying overseas (e.g., in Europe) where tuition fees often are negligible compared to the crazy high tuition fees in the US.

Never use credit cards to buy things which you cannot afford. If you use a credit card to pay for things, think of it as cash. You always need to have enough cash to pay off the full balance on the credit card at the end of each month. Never carry forward a balance on your credit card account, and thus never pay interest. Use credit cards only to earn sign-up bonuses and rewards such as cash back or miles. Read this post to learn more on how to use Travel Reward Credit Card to get free flight tickets.

Don't buy new cars. They lose around 20% of their value in the first year. Instead, "FI on Steroids" recommends to buy slightly used rental cars well below market price (see this post). Therefore, a car purchase price should never be too high. I would never pay much more than $20,000 for a car. If you already followed the path to FI for a while, you should be able to pay cash for a car. There is nothing wrong with that. You will avoid paying interest on a car loan. However, if you are able to secure a car loan for a 2 - 4% APR, you can invest the $20,000 in an S&P 500 index fund or ETF where you most likely will earn 8 - 11% per year while you can borrow the $20,000 for the car from a bank at a lower rate of 2 - 4% per year. This is one of the few exceptions where I would take out a loan. Simply because I can borrow money from a bank for less than what I can make in the stock market.

Home ownership is a controversial topic discussed in detail in this post. Home loans normally have much lower APR than car loans and credit cards. Living has a certain cost. Either you pay rent or you own a home. If you rent, you pay for rent and renters insurance. If you own a home, you pay mortgage (unless it is already paid of), HOA fees, taxes, homeowners insurance, and maintenance. In some locations, home ownership might reduce your cost of living compared to renting. In other words, the total of mortgage payment, HOA fees, taxes, homeowners insurance, and maintenance might be less than the total of rent and renters insurance. In other locations, renting can lead to lower cost of living compared to home ownership.

While most people think that a house is a good investment, "FI on Steroids" argues that a house is not an investment at all in most cases. An investment needs to appreciate and generate money. For example, stocks might appreciate and generate money in form of dividends. A house will most likely appreciate over time, even though at a lower rate than the overall US stock market. However, a house will take money out of your pocket instead of generating money for you. In fact, even if you have paid of the mortgage, you pay for HOA fees, taxes, homeowners insurance, and maintenance. You pay money instead of earning money. The only way to turn a house into an investment is to rent it out, provided that the rent you collect is more than the total cost of HOA, taxes, insurance, and maintenance.

Anyway, getting back on topic: "FI on Steroids" recommends taking out home loans only if home ownership enables lower cost of living compared to renting or for rental properties which produce a positive cash flow.