Live Debt-Free

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THAT THROBBING IN your head? That's a hangover from the borrowing binge we've enjoyed for most of this young century. And make no mistake, we did enjoy it. We bought record numbers of homes and filled their three-car garages with shiny vehicles boasting DVD players and heated seats. We regaled our friends and neighbors with the details of our cash-out refinancing -- and the ski trip to Aspen it paid for. The beauty of the whole shindig was that we could justify it financially, since the costs of borrowing were relatively low. We were like mini private-equity firms, using cheap debt as leverage to scoop up our share of the American Dream.

In retrospect, it's clear that what started as a celebration morphed into quite a bender. According to the Commerce Department, Americans collectively spent more than we earned after taxes for the past two years in a row -- the first time that's happened since the Great Depression. The household debt-to-income ratio has reached an all-time high, topping 19%. Meanwhile, many forecasters see rising inflation and interest rates ahead. Michael Hudson, president for the Institute for the Study of Long-term Economic Trends, sums things up pretty simply: "The free lunch is over."

That means that for many of us it's time for two aspirin, a splash of cold water and a new attitude toward personal finance. The new motto: The less debt you have, the happier -- and wealthier -- you'll be. And while even the caviar and Cristal crowd seldom live their whole lives without borrowing, keeping your debt load as light and as cheap as possible is the key to a more secure future and to guilt-free spending on the things you need and want.

It's a skill that's often neglected and seldom discussed, but understanding how to manage your debt will let you build wealth faster, and with less risk. Disciplined saving and smart investing are the topics that get the most ink -- hey, we read this magazine too -- but without a good debt strategy, the planning for your financial future can get awfully wobbly. The explanation comes down to Home Economics 101: Paying interest works against you in the same way that earning it works for you when you invest. The average household owes about $9,900 on credit cards at an annual rate of 15%, according to the research firm CardTrak.com, costing about $1,500 a year in interest. If a family invested that interest every year instead and earned 8%, after 30 years they would have an extra $181,700. With auto, college and even mortgage loans, the interest snowball is a little smaller because rates are lower, but you'd still much rather throw it than get hit by it.

If becoming debt-free can seem like a pipe dream, it's one that most of us share: A recent survey by the financial-services company LendingTree shows that 74% of Americans envision themselves debt-free, excluding mortgages, at some point in their lives, but only half said they have a plan for how to get there. Luckily, SmartMoney has one too -- which focuses on carrying only as much debt as you need, keeping it cheap by snagging the lowest interest rates and getting to debt freedom sooner rather than later. We've even got a finish line for our plan: retirement. After all, once a person starts living off a nest egg rather than a salary, those interest payments hurt all that much more, forcing the retiree to live on less to stretch the savings. "The people who have the most trouble are the people who carry the most debt into their retirement years," says Charles Farrell, a financial adviser in Denver. "Those fixed obligations can bury you."

To be sure, some debt -- especially a mortgage, for which the interest is usually tax-deductible -- is a prudent fit in one's financial life, especially for younger people. But as any good thesaurus will tell you, debt is just another word for liability. In trying to cope with it, many people wind up foundering because they try to employ separate strategies for each of their burdens, attacking their credit cards, auto loans and other obligations as if they were unrelated enemies.

We think there's a better way to move toward a debt-free life: adopting approaches that can generally be applied to all debt. It means, for example, speeding up payments on just about every category of debt, from mortgages to school loans, and shifting to as many "fixed" loans as possible. Below, we'll outline strategies that can be used, together or in tandem, to tackle all kinds of obligations -- in ways that can save hundreds of thousands of dollars over a lifetime.

Change the Monthly Mind-Set
Let's say the Tooth Fairy makes a rounding error at your house this month, and you find yourself with a little extra cash in hand. Sure, the approaching football season cries out for high-def television, and Tuscany is gorgeous in the fall. But for anyone shouldering a big debt load, the wisest move may be to plow that windfall right into a jumbo payment on your car, your Visa or even your house. In an era when most big purchases are handled through comfortable monthly installments, that advice seems downright counterintuitive. But let's be blunt: "Affordable monthly payment" is banker-speak for "we're making a killing on this loan." If you think of debt management as more like conventional shopping -- an opportunity to get the best product for the lowest total price -- then the smaller your monthly payments, the weaker your strategy. And if you're doing fiscal backflips to make those payments smaller, says Kenneth Kamen, a wealth-management consultant in Princeton, N.J., "that is life telling you your eyes are bigger than your wallet."

So if you're in the habit of making relatively small payments, stretching beyond your comfort zone could pay off big down the road. First priority is to knock out all credit cards, starting with those with the highest interest rates. Say you're carrying that average American balance of around $9,900 on a card with a 15% interest rate. If you pay $250 per month, slightly more than the minimum payment, it'll take 55 months to pay off the card; by upping the payment to $1,000, you can pay it off in less than a year -- and save yourself more than $3,100 in interest. The same strategies can come in handy for home-equity loans, but be sure to check with your lender about potential prepayment fees.

The "low monthly" mind-set can take an even higher toll when it comes to your auto loan. In the not too distant past, the typical car loan lasted three years. Today the average duration is almost five and a half years, according to the car-research web site Edmunds.com, and seven- and eight-year loans aren't uncommon. Drivers buckle themselves into these deals in search of lower payments, but they're headed for a long-term financial collision. Let's say you have your eyes on a $45,000 Land Rover. You put $5,000 down and finance the other $40,000 at 7%. If you spread that loan over three years, you'll pay $1,235 a month, and $4,463 in interest by the time you own the car free and clear. Spread it over seven years and your monthly payments will drop by half -- but you'll pay a hefty $10,711 in interest before the car is really yours. And all the while, of course, that Rover is depreciating, making your long-term borrowing look even sillier. By year five of the loan, there's a good chance you'll owe more than the car is worth -- what dealers call being "upside down." The good news: If you're in a loan like this, it's a great target for extra payments because most car loans don't charge prepayment penalties.


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