Things every young person needs to know about money - Chapter 7 – When do I borrow?
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” Warren Buffett
“I think people don't understand compound interest because typically no one ever explains it to them and the level of financial literacy in the US is very low.” James Surowiecki
In an earlier post I mentioned Occam’s razor as a great tool to put in place “rules of the road” for decision making. Wikipedia includes this description of Occam’s: “simpler theories are preferable to more complex ones because they tend to be more testable.” When I teach classes, this is the example I use: If I am walking my dog in rural Maryland and I hear hoof beats coming up behind me, I assume it is a horse, not a zebra. Could it be a zebra? Sure! But probability tells me it must be a horse.
The Occam’s Razor for purchases is simple. Never borrow money to pay for something that you can’t get fixed payment terms on.
Think about the simplicity of that statement! How do most people get in trouble with their credit cards? They spend money on ephemeral experiences, and eventually find themselves with smothering monthly payments and nothing to show for it. This rule stops that.
What types of purchases can I normally get fixed payment terms for? The purchase of a home to live in. The purchase of a car to get back and forth to work. The purchase of a large appliance that allows me to save money by staying home.
What types of purchases do not qualify for fixed payments? Expensive coffee, clothes, dining out and going to the bar are all examples of purchases that I can’t get fixed financing for. Can you use your credit card for those purchases? Of course! But you MUST pay off the balance every month. If not, you are in violation of this Occam’s Razor rule.
If you follow this rule, I promise you will likely avoid the trap of making monthly payments to credit card companies while simultaneously having nothing to show for it.
Next, I’ll discuss the importance of establishing a money management system.
I wanted to thank you for the overwhelmingly positive response to this series! I have received numerous communications from parents who had a positive experience sharing these posts with their teenage children. Money is an odd topic. Everyone knows how important money management is to a successful life, but we almost never talk about it with the people closest to us. I also want to apologize for the slow cadence of these articles, but I have a LOT going on!