Becoming Debt Free

Debt is a financial burden for a lot of people and reducing that debt is not always easy. Becoming debt free should be your first priority in improving your financial situation.  

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Assessing your debt

The first step towards becoming debt free is to assess your situation. If you’ve never thought much about your debt before, you’ll also learn some not-so-nice things here. To begin, make a list of your debts along with their balance and interest rate.

If you’ve never done it, see how much money you are paying in interest fees alone. If your interest is calculated annually, divide it by 12 (If it is calculated monthly, you can use the monthly amount). Divide this number by 100 and multiply it by your balance.

Example: 5% annual interest rate with a balance of $25,000. 

5%/12 = 0.417

0.417 / 100 = 0.00417

0.00417 x $25,000 = $104.17.

This debt would cost you $104.17 per month in interest alone. This is why it is important to get rid of debt as quick as you can.

Creating a plan

Creating a plan to reduce debt is pretty straight forward: Throw as much money at it as you can. Finding that money is less straightforward. Scour your budget for whatever you can find, everything you apply to a debt now is compounded interest you won’t have to continue paying.

You can pay off your debt in two ways: focus on the high interest, or focus on the lower balance. Focusing on the high interest is the mathematically optimal way, you will save the most money with this method. Focusing on the debt with lower balances is the mentally optimal way, it gives you quick small wins to keep you motivated to continue paying down your debt. If discipline is something you struggle with, focusing on the lower balance is the better method. No matter which method you choose, it is optimal to choose one debt at a time to pay off. This also gives you quick wins, and there are no benefits trying to pay down all of your debts simultaneously. How do you focus on the high interest or low balance debts? Make only the minimum payments on the debts you are not targeting. This will free you up to apply the maximum amount to the debt you do decide to target.

If your list of debts looks like this:

  • $20,000 credit card debt at 19.99% annually
  • $7,500 car loan at 5.99%
  • $17,000 in Student loans at 0.99%

If you decided to focus on higher interest debt, you would make the absolute minimum payments on the car loan and student loan and apply as much as you can to the credit card debt. Once the credit card debt is gone, you will begin to focus on the car loan. Finally you would finish the student loan. This would save you the most on interest payment compared to other methods of paying off your debt

If your list of debts looks like this:

  • $20,000 credit card debt at 19.99% annually
  • $7,500 car loan at 5.99%
  • $17,000 in Student loans at 0.99%

If you decided you could use the extra motivation of focusing on lower balanced debts, you would make the absolute minimum payments on the credit card and student loans while applying as much as you can to the car loan. After the car loan is done, TECHNICALLY you would then target the student loan, but the difference between the two balances is not really enough to give you that “quick win” benefit. The interest rate difference is substantial, however. There are not many situations where I would focus the student loan debt over the credit card debt. You would not be saving the most on interest with this method, but it is better than the alternative of losing motivation and not focusing on any of your debts.

Debt Consolidation

Debt Consolidation is a common term you may have heard before, but what is it? It is when you take out a loan to pay off other loans. Why would you do that? A main reason is to lower the interest rate you are paying or to extend the length of the debt payments to reduce payment amounts if you cannot keep up. If you have high interest debts such as credit card debt or a used car loan, it isn’t extremely difficult to consolidate it to a lower interest debt.

You have $3,000 of outstanding credit card debt accruing interest at a 22.99% rate and a$15,000 used car loan accruing interest at a rate of 6.99%. You find out you are eligible for a line of credit of $20,000 at 4.99%. Performing a consolidation like this would save quite a bit of money on interest and allow you to pay off the debt much quicker.

Staying debt-free

After paying off your debts, it important not to slip back into the bad habits. If you use a credit card, pay it off each month before you accrue interest on it. If you can’t pay it off, avoid spending the money. On top of that, don’t finance other purchases. You can finance everything these days, from phones to new furniture. Avoid it. Save for it, THEN buy it. 

Many places offer 0% financing when buying their product. Surely it would be stupid not to take advantage of this when buying things, right? Yes and no. For things that have seriously depreciated resale values, you should follow the rule stated above about saving for it first. This includes furniture, electronics, tools and the majority of any other luxury items you could finance. Financing things usually costs the businesses doing the financing, by paying up-front you may be able to negotiate a discount. If not, there is no real reason not to take advantage of the 0% financing but it is still smart to have at least most of the cash available to pay for it.

Good Debt and Bad Debt

You will hear people talk about good and bad debt. They say low interest debt (such as a mortgage) that you can beat the interest rate by investing the money instead of applying it to the debt is good debt. High interest debt you cannot beat is bad debt. Investing money instead of paying down a debt adds risk. Unless the interest rate is VERY low, it is typically better to pay off the debt. I personally would focus any debt over 3%. For things I have with lower than a 3% interest rate (a mortgage), I continue to pay them but it is more than ok to put some money towards investing instead.