In 2004, at the Berkshire Hathaway annual meeting, a 14-year old shareholder asked Warren Buffett, Berkshire’s chairman, and CEO, to share his top finance tips for young people.
“If I had one piece of advice to give to young people,” Buffett responded, “it would be just to don’t get in debt.“
“It’s very tempting to spend more than you earn, it’s very understandable,” he continued. “But it’s not a good idea.“
This wasn’t the first time Buffett warned investors about the dangers of debt, and it certainly wasn’t the last.
Stay away from debt
Today, it is all too easy to apply for a credit card, personal loan or personal contract purchase (car finance). Lenders are keen to make the most of the current credit environment because they can borrow cheaply (often at less than 1%) and then lend these funds out to consumers at rates three to four times higher (or more than 25 times higher for credit cards!)
It seems British consumers just can’t ignore these deals. According to the Bank of England, personal debts rose to £200bn last year, of which £70bn was credit card debt.
However, despite how attractive these deals might look, if you want to achieve financial independence, as Buffett says, it’s always best to stay away.
The problem with debt
The way I see it, the big problem with debt is that it is easy to accumulate, but difficult to pay down.
If you need to use a credit card to make that big purchase, you are almost certainly spending more than you can afford. If you are spending more than you can afford to start with, how are you going to pay the money back with interest?
Indeed, adding interest on debt can quickly turn your borrowings from a manageable obligation into an unsustainable habit. Most credit cards charge interest rates equivalent to 25% per annum which, according to my figure, means every 2.9 years, the amount you owe will double.
Many credit card companies and other types of lenders offer introductory deals on credit to new customers. Such as 0% interest offers. These might seem innocent, but they’re designed to draw you in — the high fees come later.
And because debt is easy to accumulate, but difficult to pay down with interest added on, it is easy to fall into a debt spiral.
Debt spiral
A recent BoE survey showed £9 out of every £10 of outstanding credit card debt in November 2016 was owed by people who were also in the red two years earlier. This shows that most people who build up credit card debt, are really spending more than they can afford. These numbers also imply people are struggling to pay off their obligations, which implies they are also not saving.
The fact of the matter is, if you want to achieve financial independence you need to save money. You can’t save money if you’re trying to pay off your debts. So, the best solution is to avoid debt altogether.
It may not be fun, but over the long-term, I believe the financial freedom gained by remaining debt-free will certainly be worth it.
