If one of your goals this year is to get your finances in check, we’re here to help. Managing your finances can quickly feel as if you’re drowning in numbers and questions, but once you dedicate a few moments a week to practicing good financial habits, maintaining your funds can be simple. You can start the process today, easily.
In this post we'll outline how to understand, manage, and pay off most kinds of debt.
An overview to paying off debt:
Calculate your monthly expenses: From those random $3.00 coffee trips to your monthly rent payments - all of it needs to be tallied up and totaled.
Take Stock of your debts: Do you have more consumer debt to pay off, or larger loans? What are the interest rates on your lines of credit? Find out all of this information and consolidate it in one place.
Analyze where you can cut back: Where can you afford to downsize? Should you consider a different phone plan, start taking public transit, or cut back on eating out at restaurants?
Pay Off Debt: Two common methodologies for paying off debt are:
- Snowball Method - pay off your smallest debt first. The psychological effects of completing one goal can then snowball into the rest of your debts.
- Avalanche Method - pay off debts with the highest interest first. This is traditionally seen as the most cost-effective way of paying off debt.
What is debt?
The Oxford dictionary defines debt as “something, typically money, that is owed or due”.
In the most simplistic terms, debt is the amount of money you’re borrowing money from someone else so you can purchase something and pay them back later.
There are some forms of debt that are necessary to help you build and establish wealth. On the opposite side, there are forms of debt that can damage your credit score. Let’s take a deep dive into these forms of debt.
A good rule of thumb to see if your debt is considered good or bad is to ask yourself: “Will what I’m purchasing with this debt help me make money in the future?”
Good debt can help you generate income and increase your net worth, making it a smart decision to consider taking on some debt for a longer-term finance strategy. In other words, if your debt can be considered an investment for the future, it’s good debt.
Here are a few examples of good debt:
- Mortgage Loans: Purchasing a home is a good long-term investment strategy. Mortgage loans often have low interest rates and are deductible from your taxes. Your property also has a major opportunity to increase in value over time - which you can then use in the future for home equity loans.
- Student Loans: With education becoming more expensive, it can feel like it’s impossible to get your degree without taking out a loan. But the good news is that with a degree comes the increase in earning potential and more opportunities for better employment. It's just critical to have a plan to pay them off.
- Small Business Loans: Starting a business can be challenging and expensive. However, you can really open up financial opportunities for yourself if your business succeeds. Think about how your finances may change if you sell your successful business in the future or if you considering opening up an IPO.
- Home Equity Loans: This type of loan allows you to use your physical home as collateral, so your loan is completely based on the value of your home. This is done either as a full loan or a line of credit. The downside is that if this loan is not repaid, the bank has the opportunity to foreclose on your home.
Similar to good debt, bad debt is easy to identify based on how the value of the item you’re purchasing changes over time. Some qualities of bad debt include high interest rates and the depreciation in the items value over time. Checking the interest rate is important, because loans with high interest can add quickly become unmanageable over time.
Let’s take a look at a few examples of bad debt:
- Car Loans: While new cars can be a fun thing to have and drive, they are one type of asset that very quickly decreases in value - so much so that you can lose about 10 percent of your car’s value during the first month you drive it off the lot. Paying interest for something that depreciates this quickly can put a huge dent in your wallet.
- Credit Cards: While many credit cards incentivize you to use them with points or cashback bonuses, the truth of the matter is that most credit cards have extremely high-interest rates with low minimum payments. If you’re only paying the minimum payment on your credit cards, your interest will cause your balance to grow very quickly, making it a huge challenge to pay back. Plus, missing payments can greatly affect your credit score.
- Payday Loan: This type of loan is extremely short-term, but the kicker is that the interest rateis extremely high. A payday loan is often paid off in a single amount, often due the next pay period. The most common way lenders ensure that they get paid is to have a debtor write a check for the amount of the loan, in addition to the interest that lender assigns. If you cannot pay the day back, you end up having to pay just the interest, which can be up to 500 percent of the original loan.
What is interest?
If borrowing money for free sounds too good to be true, that’s because it is. When you borrow money, you pay for it in the form of interest.
Interest is how much it costs for you to borrow money, and how much you pay is commonly calculated as a percentage of the remaining amount you still need to pay off, or otherwise known as the balance.
Essentially this means if you borrow money, you will be repaying your lender MORE than what they initially gave you to borrow. The longer it takes for you to pay off your debt, the more interest you will pay.
The only way to ensure that you don’t pay too much interest is to ensure that you pay off your loan quickly and efficiently. Most of the time, your interest is already included in your monthly payments - some of your payment goes to actually repay your debt, and the other part is part of the interest. Common forms of loans, such as mortgages or car loans, will have time restrictions on them so that you can pay off your loans within a specific time period.
How to pay off debt
While borrowing money to buy things and then pay it back later sounds convenient, it can very quickly put you in the negative in terms of your funds and can affect your credit score.
By taking the time and energy to pay off debt, you’re also missing out on saving opportunities such as an emergency fund or for your retirement.
There are a few different strategies you can use to help pay off debt. These strategies work with the assumption that you are paying the minimum payments on all of your debt.
The Snowball Method
Popularized by author Dave Ramsey, the Snowball Method is a strategy for tackling debt bit-by-bit. With this strategy, your goal is to focus on your smallest loan first. After creating your budget, use any of the excess funds from your budgeting process and put it completely into the loan you’re focusing on. Once that one loan is paid off, move on to the next one. And then the next one.
Eventually, you will have snowballed your way through all of your debt! This strategy is a great way to tackle your debt little by little and can help you get rid of big loans in a fairly short period of time. With this strategy, you can often tackle a small loan in just a couple of months, which in turn can further motivate you to continue paying off your debts.
The Avalanche Method
While strategically similar to the Snowball Method, the Avalanche Method focuses not on the size of a specific loan, but instead on the interest rate attached to it. By focusing all of your focus on the loan that has the highest interest attached to it, you will be minimizing the amount of interest you’re paying for.
This method is the most financially smart method, as you will be paying less on your debts in the long run. However, this strategy could be more challenging to keep up in the long-term.
Which strategy should I use?
While there is no one right way to pay off your debt, there are few things that are known to be true:
- Focusing on one account at a time is easier. If you spread your funds out too much, the steps you make can feel negligible in terms of progress.
- Stay committed. It’s easy to slip up. Managing money is HARD. But even if you do slip up, get back on track and keep going according to plan.
- It’s all personal. Do what you feel is best for you and your financial situation, even if that means taking a little longer to pay off debts. If you start feeling discouraged, realize that you can’t sustain paying a certain amount on a loan, or feel as if your strategy is not moving the needle, switch it up! It’s all about what works for you.
And then what?
Emerging debt-free can be a truly revitalizing experience. The important part is to ensure that you stay debt-free. Some debts are unavoidable, such as mortgage loans, but if you can, choose options for your lifestyle that enable you to stay debt-free.
Next week, we will be talking about what to do after paying off your debt - building a solid savings foundation and an emergency fund.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.