Updated: May 18, 2021
Today will likely be almost everyone’s least favorite topic on personal finance, but it is vitally important to discuss and manage. We’ve covered goals, net worth, income, and expenses. Today is the day we will discuss the four-letter word in personal finance everyone dreads: DEBT. Consumers in the United States, as a whole, are saddled with debt. At the end of June 2020, consumers in the United States were in debt by a total of $14.56 trillion. The largest debt amounts are due to mortgages ($10.39 trillion), student loans ($1.56 trillion), car loans ($1.37 trillion), and credit card debt ($820 billion). This might be everyone’s least favorite topic to talk about, but once you have a plan for your debt, it’s easier to start moving forward to pay it down and pay it off. Let’s get moving on Step 4: Tackling Debt.
Debt
You likely know what debt is. Debts, when talking about personal finances, are amounts of money you owe, usually to financial institutions, and normally in the form of loans. The most common types of debt today are credit card debt, student loans, car loans, and mortgages. Some of you may have debts in most of these categories, and some of you may have only one or even none of these categories. Debts can come from different sources and in vastly different amounts. Not all debt is necessarily bad, but it can definitely cause stress.
Compound Interest Can Work Against You Too!
Many of you know, or if not, you can read about it here, that compound interest is the most powerful tool to grow savings and investments. However, what is not emphasized enough is that compound interest can also work against you. Just like your nest egg grows over time, so can your interest costs on debt. Previously, I discussed how consuming using debt (mainly credit cards) costs more in my “Are You a Victim of the Diderot Effect?” blog post, and I’ll add another example displaying how carrying a balance on your credit card balance will cost you a lot more money. If you have $500 of credit card debt at a 15% interest rate and want to pay it off in 3 years (36 months), you will end up making 36 payments of $17.33 per month for a total of $623.99. Whatever you spent that $500 on, will actually cost you 24.8% more than you paid for it after you pay an extra $123.99 in interest to the credit card company. Additionally, in this simplified example, the assumption is that no additional charges are carried on that credit card, which would further increase your debt and interest costs.
Even legendary investor Warren Buffet recently said debt with a high interest rate is the first place to put extra money you have, similar to what I wrote about if you received a stimulus check. He said, “If I owed any money at 18%, the first thing I’d do with any money I had would be to pay it off.” Buffet was referencing an example using 18% interest, but I would say you should pay off any debt as fast as you can that is over 8%. Why 8%? Because that is the historical average return of the S&P 500 from 1957-2018. If your savings and investments will not grow faster than the historical growth rate of the stock market, you’re better off putting that money towards high-cost debt. Personally, I’d probably make that interest rate even lower, maybe even 6%, because paying off debt with a 6% interest rate is a guaranteed savings on the money I’m putting towards the debt.
Start Tackling Your Debt
To start, list all your debt accounts along with the following information:
– Account Name
– Account Type (mortgage, student loan, credit card, car loan, etc.)
– Lender (who leant the money to you)
– Total balance outstanding
– Monthly Payment or Minimum Monthly Payment
– Interest rate
– Expected payoff date
If you use a spreadsheet, you can also include the web address. That way, you have an easy way (by clicking the link) to check your debts and get to the websites for each debt.
Once you organize your debt accounts, it’s time to set up a plan to pay down your debts. Tackling excessive debt can be difficult and stressful, but it has been done successfully over and over by people. The relief that comes with paying off a debt relieves stress and will encourage you to pay off the next debt.
There are two main methods for paying off debt. One way is to start with your highest interest rate debt (usually credit cards), then moving onto debts with lower interest rates. Another method, which is great for a major psychological win, is to start with your smallest debt and pay it off as soon as possible, and then start working on the next largest debt. This victory of completely paying off a debt, no matter the size, can be a big step forward for a lot of people. Paying off a debt is an accomplishment that not only shows you it can be done, but that it can repeated as well. Paying off the highest interest rate debts first will save you the most money, but if you need the win of getting a debt paid off, you can certainly go for paying off the lowest amount first.
The key to paying off debts faster is to pay extra, and when a debt gets paid off, apply what you were paying towards the paid off loan to the next debt you want to pay off. And keep building your extra contributions toward debts in a similar manner until you have paid them all off or at least the high interest debts. Additionally, you should put most, if not all, of any pay raises you receive towards paying down your debts. The bigger the payments you make to pay off the debt, the faster the debts will be paid off and the less you’ll pay in interest. As you continue to pay down and pay off debts, the weight of the debts will feel lighter and lighter, and your stress due to the debts will be less and less.
Aggressively, paying off debts will allow you to transition into Step 5: Ramping Up Your Savings.
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