photo credit: caswell_tom

Living debt free is a lifestyle choice that had become a bit of an oddity in recent times with the availability of cheap credit and the constant increase in house prices. Many people are now starting to try and live this way (or work towards it) because of the credit crisis. Some will be doing it by choice, to secure a better standard of living for their family in the future and some will be doing it because they have no option (they can’t get any credit).

Why Living Debt Free is Good For You

Let me first clarify what I mean by living debt free. I am really talking about unsecured debt. Avoiding unsecured debt is something that most people can do (excluding medical emergencies). Avoiding a mortgage is not realistic for most people. I would suggest that you work towards living free of unsecured debts (credit cards, personal loans etc.) and then try and pay your mortgage off as soon as you can.

Whilst it may seem that people that indulge in debt enjoy a better lifestyle than those that don’t, this is an illusion and is not true over the long term (unless very unusual economic factors are in place, as in the 1970s). Let me explain by the use of a very simple example budget (apologies if you think this is a bit patronizing) :

Putting Your Vacation on a Credit Card

If a family has a monthly income of $2000 and monthly essential payments of $1000. They have $1000 a month to spend on food, clothing and anything else. If they want to go on a vacation that costs $2000 and they put it on a credit card that will cost them $100/month (5%) in monthly minimum payments. On average this will take about 4-5 years to repay if repayments are kept at the minimum level, giving a total cost of approximately $4,800.

This family will have spent $4,800 to go on a $2,000 vacation and their monthly spending budget for the 4 years after their holiday will have decreased by $100 initially.

Saving Up For Your Vacation

Take the same family budget and vacation cost. This time imagine that the family decide to save up for their vacation by putting aside $80/month. This will take them only 2 years to do allowing for some credit interest (more than 2 years less than it took to pay off the credit card debt). During this time their monthly spending budget will have been reduced by $80 but they will have access to their savings if they need them for an emergency.

Spending Tomorrow’s Money Today

If you take the above example and roll it forward a few years you can see how the family that uses credit for their vacations or other leisure expenses will very quickly spend their entire monthly budget on credit card bills (if the banks will lend them the money) for things that they enjoyed in the past.

The family that save up will have some savings built up and will be able to decide whether they can afford to go on a vacation without making any assumptions about their future income or deductions from it.

Does Borrowing to Spend Ever Make Sense

There are particular circumstances that make borrowing to spend more sensible than usual. One is where there is a negative rate of real interest (where wage inflation exceeds interest rates) for a prolonged period of time (as in the 1970′s). When this is the case the value of debts are eroded very quickly by inflation. Another instance where borrowing makes more sense (although this is really borrowing to invest rather than borrowing to spend) is where there is rapid asset-price inflation. In this instance the price of assets can be increasing faster than your ability to save up for them.

Making a Commitment to Living Debt Free

Living debt free is tough at first, especially if you have already built up debts. These will need to be cleared before you move over to a savings-based budgeting system. The rewards in the long-term will be worth it though.