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Welcome to Financial Fridays #4! Over the next 3 weeks – every Friday from now until the end of 2017 – I’m going to share posts that will help you paint a picture of your financial life today and set you up for a prosperous 2018. We’ll touch on topics ranging from income and expenses to net worth, debt, career advice, and setting goals.
These are some of the steps Kristin and I have taken to help set ourselves up to be able to afford our dream wedding, dream house, and plan for early retirement. Of course, a healthy dose of privilege helps and I’d be remiss to not mention how fortunate we’ve been in that regard.
If you’re looking to make 2018 a better year financially than 2017, tune in every Friday for the rest of the year!
Why Fridays? Each post will have a set of actionable items that could be achieved easily over the course of a weekend!
Did you miss last week’s post? If so, give it a read.
Financial Fridays 4: Make Your Plan to Destroy Debt
You even know what your credit score is – whether or not you like it, it exists. Want to improve it? Great! This week’s post can help.
This week is all about tackling any debt you have. If you don’t have any debt at all, congrats – you can skip this post!
But if you’re like the millions of Americans straddled with credit card, car, student loan, or mortgage debt, keep on reading.
Why Tackle Debt?
Debt sucks. It literally sucks money from your bank account every month.
That being said, there can be some not-horrible uses for it.
Sometimes debt can help you afford an income-producing asset like a rental property. It can also be used as a hedge against inflation.
In the US where interest rates are still super low, locking in a rate for 30 years on a mortgage means that over time as inflation rises, the value of the dollars committed to paying that debt shrink.
But even if it’s a good hedge and can help you in some cases, living a debt free life has a ton of benefits. For starters, being debt-free means that in the event of something like a job loss, you can stretch an emergency fund longer.
There’s also the mental peace-of-mind that comes with being debt free. For many, money is as much emotional as it is mathematical (if not moreso).
So, the war on debt must begin.
To start off this week, make a list of all of your debts. Anything you owe on a credit card, car loan, student loan, personal loan, mortgage, HELOC, or anything else belongs on this list.
Action: Total all your debts. Include some sort of name (the bank/card for example), the amount, the term (i.e. is it a revolving account like a credit card, or a 6-year car loan, or a 30-year mortgage?), the interest rate, and the minimum payment.
Classify Your Debts
Remember how I said that sometimes there are some not-horrible reasons to have debt? It turns out that not all types of debt are created equal.
While all debt can cost you money – in the form of interest – some debt can be better than others. By classifying your debt and breaking it into a few categories, you can make a better plan to destroy it. Here are the categories I use.
High Interest Debt
This is the worst kind of debt – the stuff that’ll kill your net worth. Anything 10% or above falls under this category. Usual culprits include credit cards and some personal loans, depending on your credit score. The preference is to kill this debt ASAP.
Medium and Low Interest (non-mortgage) Debt
Once you start getting down to single-digit interest rates – between 5 and 10% – things become a bit less painful. Some promo rates or personal loans likely fall here, as well as maybe some auto loans.
This debt should be destroyed, but most likely after high interest debt unless it’s just on a promo period after which the interest rate would hike up.
Low Interest and Mortgage Debt
Anything less than 5% falls in the low interest category. Typically mortgages will fall in or near this (higher rates for rentals, for example). Low interest debt tends to be less stressful and, dollar-for-dollar, is less expensive to carry.
Frequently, this debt may or may not be tax deductible. The main argument for keeping low-interest debt is that historically your money would be better off investing in the stock market as opposed to paying off low interest debt.
Ultimately since these debts tend to be less expensive than opportunity cost of not investing, it’s your call as to the degree you want to include these in your debt payoff plan.
Action: Categorize all of your debts into the three buckets above.
Pick Your Debt Pay-down Methodology
Now comes the fun part. With your debts listed out and all their details at your fingertips, it’s time to decide the first victim. Your first victim will be determined by the strategy you choose to implement.
This decision will be primarily based off your feelings around debt, and how much you value non-tangible benefits such as emotions, and how quickly you need a ‘win’ in your life.
The Debt Snowball
This is the path to the quickest win. Often times if you’ve got a lot of debt, just getting ONE less card to worry about paying is helpful and gives you the motivation you need to keep pushing forward.
Dave Ramsey is a big proponent of the Debt Snowball for this very reason. He argues that people need the psychological boost that comes off with eliminating a debt. Therefore it makes sense to start with the easiest – the one with the smallest balance.
If you choose this strategy, you’ll order your debts by the total outstanding balance, lowest at the top.
The Debt Avalanche
A mathematically superior method, the Debt Avalanche works similar to the Debt Snowball. Instead of ordering them by balance, they’re ordered by interest rate. Focusing on the highest interest rate ones means that your dollars will pay off the most costly debts first.
Mathematically this yields the highest ROI. However, it could also take a long time for that highest-rate debt to be paid off. That can be discouraging. If you think you might not be able to stick with it paying the same number of debts for a while, this may not be the best approach.
If you choose this strategy, you’ll order your debts by interest rate, highest at the top.
The Debt Bonfire
If one of your debts just pisses you right off, the Debt Bonfire might be for you. An emotionally motivating method, the Debt Bonfire focuses on paying down the debt that keeps you up the most at night. Shout out to Veronika at Debts to Riches for this one!
This has a few elements of the snowball – like a good win – but may not be mathematically the best.
If you choose this strategy, you’ll order your debts by how much they piss you off, the most frustrating at the top.
Action: Choose your strategy. Order your debts accordingly.
Find Wiggle Room in Your Budget
Ask a personal finance blogger if they can find money in your budget and 9 times out of 10 they’ll say yes. As a general population, we’re quick to find things that ‘could’ be cut out.
I realize not everything is going to be negotiable. Some things you just don’t want to part with because they’ll keep you sane during your debt payoff mode.
Finding alternatives can sometimes be the best way to help trim your budget so you can destroy debt. Often times it won’t even be much of an impact, like when we ditched cable TV and switched to credit score.
When you’ve got your budget down, figure out how much extra you can throw at the top debt on your list. Commit to doing it, and set up automatic payments if you can.
Action: Write down your strategy, and cut costs where needed. Stay the course, continually adding to how much you’re paying toward the highest-priority debt as others are eliminated. If it helps, get a financial buddy to keep you motivated and on track.
Stay The Course
Paying down debt is a long process. You will go through periods of highs and lows, confidence and doubt. You may read tons of success stories – don’t let their quickness discourage you, but rather use it as sources of inspiration. See what little nuggets you can take out of these stories you read and apply in your own life.
The path to becoming debt free – and later financially independent – can be a long one, but it’s a worthwhile one to follow.
What’s your favorite strategy for tackling debt? Any special tricks you use to keep yourself motivated?