This is the second of ten posts describing the key pillars of building a strong financial foundation. Read the introduction here. Check back each Monday for the next post in the series.
What is it?
Debt is a scary thing for a lot of people, but some people don’t take it as seriously as they should. Having a substantial amount of debt can hinder what you are able to do with your life and can force you down paths that you don’t want to take. Careful planning of when you take on debt and how much of it you can handle is an important piece of building a robust financial foundation.
Good Debt vs. Bad Debt
A lot of personal finance literature describes debt as either good or bad. Good debt is a liability that appreciates in value, while bad debt depreciates in value. For example, if you went to college but had to take out student loans it would be considered good debt because attending college increases your overall earning power for your lifetime. Until lately houses had been considered good debt, but with the decline in housing prices over the past few years the appreciation of a house is not as certain as it used to be. Good debt should not be used as an excuse to take on tens or hundreds of thousands of dollars of debt when you don’t need to though. An example of this would be buying more house than you can afford or attending a more expensive school than you need to.
Bad debt would be a new car payment, consumer credit card debt or any other outstanding liability that doesn’t grow in value. These debts are considered bad because you will be paying interest on purchases that won’t be earning any money to offset the interest you are paying. For example, if you take out a 6% loan to purchase a brand new $30,000 SUV you will be paying $1,800 extra in interest within the first year alone! When deciding whether or not to take on bad debt, think about whether you need the item you are purchasing or if you could save up the cash for it first. Avoiding paying interest throughout your life can lead to gaining financial independence more quickly.
How does debt hinder freedom?
Having outstanding debt can lead to higher interest rates on future loans, a lower credit score or even repossession of assets that are not being paid off. Beyond the financial burden that debt can be, the emotional part of debt can be a huge hindrance to your life. Being debt free can give you freedom to do what you really want with your life instead of being stuck in your current situation.
Immediately after graduating college I had school and car loans to pay off. I knew that I couldn’t afford to lose my day job or try a risky venture because I had debt to repay. I had to work hard at a job that wasn’t directly related to my passions just so that I could save up the $27,000 that I owed. After 29 months I reached my goal and sent in the final payments. That day I felt as though a large weight had been lifted from my shoulders. Even though my net worth had been positive for a while already (due to my retirement accounts) I wasn’t technically debt free until I made that final payment. It was as though blinders had been removed from my eyes and I was free to do anything with my life.
Why shouldn't you just pay the minimums?
Paying just the minimums on outstanding debt is a great way to waste a lot of money. Don’t get me wrong, you should be paying at least the minimum payments on your debt as not doing so will hurt your credit score significantly. But by paying only the minimum on your outstanding debt you will be paying it off for a long time and you will be spending a lot of your money on interest.
Credit card companies and banks make their money by collecting interest on their outstanding loans. Most credit cards have double digit percentage interest rates and school and house loans have mid to high single digit interest rates. When your school loans or mortgages on a house are set for twenty or thirty years, you pay a majority of the interest in the beginning. To see exactly how much you will pay in interest over the full term, use an interest calculator like this one. Doing this calculation just once on my school loans showed me how important it is to pay them off early.
How to get out of debt
There are multiple systems for getting out of debt. The best mathematical way of paying off your debts is to pay off the ones with the highest interest rate first. This system will have you paying the least amount in interest as possible while you pay them all down. This is the system I would use if I had multiple types of debt to pay off.
Another popular system called the Debt Snowball (made famous by Dave Ramsey) has you paying off the debt with the lowest dollar amount first. This strategy focuses more on the psychological factors involved with paying off the debt and allows you get more momentum built on your debt repayment.
Make it Automatic
One or a hybrid of the two above methods will only work if you stick with them though! A key component of paying off debt, along with building savings, is to make it automatic. To pay off my debt I set up the direct deposit directly from my paycheck to send a portion to the loan payments. By keeping the money from hitting my personal checking and savings accounts, I didn’t spend the money needlessly on other things. I also locked in the savings for my school loans into Certificates of Deposit while they were in forbearance so that I would be less likely to touch it.
There are banking services available that can manage this for you – basically offering you two accounts in one. One for your bills, and another for your disposable income, which is yours to spend as you wish. Or maybe this alternative to a basic bank account could be for you if you struggle to manage this aspect of your finances.
Living within your means and avoiding debt, even if its good debt, can open up doors throughout your life to give you more options. The ability to avoid debt will create freedom in your life and provides you more versatility. You could easily change careers, go back to school or move halfway across the world if you want to. Think long and hard about anytime you are considering taking on more debt.
Do you have problems with debt or have advice for how best to pay it off? Feel free to leave a comment below.
Financial Foundations Series