Debt 101: Eliminating and Staying out of Debt
As we like to say, debt is the devil. Debt can be the ultimate menace in your wealth-building journey. We do not care if your savings account is earning 7% interest; your debt will find a way to destroy you financially. One of the biggest influences on building wealth and financial freedom is eliminating and staying out of debt.
If we look at the net worth equation: Value of Assets – Value of Liabilities, we can see how detrimental debt can be.
First, we will look at assets (anything that you can consider to be making you money). We will say you have $20,000 worth of stock. This investment is an excellent start in your asset acquisition journey. At this point in your life, this is the only category that you have assets in, so the value of your assets is $20,000.
Now, if we look at your liabilities (anything that is causing an expense). You have student loans of $39,000, a car loan of $12,000, and credit card debt of $4,000.
To determine your net worth you are going to take your $20,000 worth of assets and subtract it by the $55,000 worth of liabilities you owe.
- $20,000-$55,000= -$35,000
This is a perfect example of how detrimental debts can be. Even though you have $20,000 worth of stock, your net worth comes in at -$35,000. Anything in the negative is obviously detrimental to your financial well-being.
The good news is that anybody can recover from these adversities. The reason that you go to college is to earn more money in the long-term. Maybe, you had to use your credit card to pay for food and books while you were there. You also needed a car to get to work to make a living.
There are viable reasons that people get into some debt. Most people cannot afford a house without some debt, and debt can work to your benefit when buying a rental property. The key is to limit it when you can and to get rid of it as soon as possible.
Eventually, you will reap the rewards of being in the positive, be able to invest more money, and save more money. But not if you continue to rack up liabilities and destroy the benefit of your assets.
The main problem is people that use their credit cards for every purchase and pay the minimum every month. They continue to spend and spend without actually making any progress on their bills. Please. do not be like the many people that do this. Our advice is to use your credit card if you can afford to pay it off at the end of every month.
Steps to Getting out of Debt
1. Create a Budget
The first key to staying and getting out of debt is to develop a personal budget. Doing this will put you on track to positive net worth. Budgeting allows you to understand what you are doing with your money and what you should be doing with it. This process will help you to save money month after month and be able to allocate those funds to a better place (yes… paying off your debt). Your organized finances will be in complete control.
Creating a budget will also reduce the stress that is associated with having large amounts of debt. There will be no more scrambling around to figure out how you are going to pay your credit card bill at the end of the month. You will have already allocated the payment into your budget.
Lastly, you will be able to have an understanding of what your financial goals are and what you can do to achieve them every month. Little by little, you will eliminate debt and see your financial dreams coming true.
2. Lower Your Interest Rates.
If you took out loans at a time when interest rates were high, it may be a good idea to consolidate or refinance your loans. A perfect example of this is with student loans. If you have three different student loans at 4.5%, 4.75%, and 5.15%, refinancing them at 3.5% is a no brainer. Instead of wasting money paying off interest, you will be using your money toward the loan principal. Over multiple years, this can significantly decrease the amount of time it takes to pay off loans.
Many different companies will refinance or consolidate your debts. Be careful, however, as companies will charge a fee for their service, multiple service charges, or give a higher rate. The rate at which a consolidation company will offer depends higher on credit score, so if you have a low credit score, it may have a factor in your decision.
We recommend using a consolidation or refinancing calculator to determine if it is a good option for you. These tools will be able to help you determine if you will be saving money or time paying off your loans. If the calculator shows a better financial outcome, do it.
3. Pay More Toward Debts.
The sooner that you can pay off debts, the more money you will save. The longer you take, the more interest you will be paying. This difference is why you should be paying more than just the minimum on your loans if you can afford it. Usually, you will be able to afford a lot more than you think. (Use your budget, please).
Let’s look at a loan of $3,000, say that the minimum monthly payment is $74, and the interest rate is 7.5% per year.
Years to pay off with minimum monthly payment ($74):
Total Amount Paid:
Years to pay off with $100 monthly payment:
Total Amount Paid
As you can see, you can save $200 in a year just by increasing your monthly payment by $26 per month. You want to be paying off as little interest as possible. This avoidance gives even more reason to pay debts quickly.
4. Make More Money
If you make more money, you will have to pay off your loans. Sometimes, it is not possible to get a raise. If you love your job, we are not telling you to quit for one that pays more. However, consider a small side hustle. It does not have to be much. It could be mowing a few lawns around the neighborhood, driving for Uber or Lyft, or starting a blog that makes a few bucks a month.
When you have extra income to budget, you should put it towards your debts. We already learned that even $25 extra on each monthly payment pays dividends. Therefore, make a little extra money on the side and put it towards those loans. This money will help to not scramble to find that extra money to put toward your monthly payments.
5. Use a Proven Debt Payment Method
There are two popular, proven debt payment methods that we want to touch on. Both work, have their pros and cons and will help you to pay off your debt as quickly as possible: the snowball effect and the avalanche effect.
The Snowball Effect
This method has gained a lot of fame from Dave Ramsey. The idea simple.
First, list your debts in order from the smallest dollar amount to the largest dollar amount. Do not worry about the interest rates of each debt.
As you pay your monthly bills, pay the minimum amount on all of your debts except the smallest one. Take all the remaining funds you have for paying off debt (use your budget) and put it all to the smallest debt.
Over time, you will pay off your smaller debts one by one causing a snowball effect. Each time you pay off a debt, you will have more money to allocate to the next. Once you left with your largest debt, you will have tons of extra money to put toward it. Each debt will end up being paid off at a quicker rate than the last.
The biggest problem with the snowball effect is the possibility of extra costs in interest build-up. Since this method does not worry about the interest rate associated with debts, this can be an issue.
The Avalanche Effect
This method is extremely similar to the snowball effect except for one key difference.
In this method, list your debts in order from the highest interest rate to the smallest. Just as the snowball method, you want to pay the minimum on debts except for the debt with the highest interest rate. Over time, you will pay off the debts that will cost the most in interest. This method is built around saving the most money on interest build-up.
The biggest problem with the avalanche method is that it may take a long time for you to pay off some debts with a high-interest rate. If this is the case, your smallest interest rate debts will still be adding interest, so it may end up costing more than the snowball effect.
Which Method is Best?
Choosing a method that is best for you is completely based on your debt situation. An easy way to compare these two methods is by using a snowball vs. avalanche calculator.
A calculator will tell you exactly how much money either method will end up costing in the long-run.
Be sure to utilize your budget when using either of these methods in order to maximize your payments on any given debt.
Steps to Staying out of Debt
1. Utilize Credit Card Usage
Wealthy Whisper will never write about credit cards being a bad thing. They can be, but they can also be great. Many credit cards will give cashback, points, and miles rewards for using them, which we consider free money. As long as you pay your card off in full at the end of every month, you will not only be gaining these rewards but will be building an excellent credit score as well. If this is the case, it is ignorant not to use credit cards.
However, many people cannot be responsible with their credit cards and dig themselves in the worst kind of debt. If this is the kind of person you are, hide your credit cards. Do not close them all, because you may need them in case of emergency. Focus on paying them off and not using them to build more debt. Hide them, lock them away, or give them to someone you trust. Be accountable and stop using your credit cards for things that you cannot afford. Only pay cash for what you buy and pay your bills through your checking account.
For the last time in this article, we are going to talk about budgeting. Just do it. It will be the thing that keeps you out of debt forever.
3. Don’t Make Unnecessary Purchases with Debt
This ties in with credit cards, but there are other cases as well.
If you have a car that works, do not take out a loan because you want a new one. If you have to take out a loan because you need one, do it if the circumstances are right and you are in a good financial place to be able to pay it off in a timely fashion.
There are four main types of debt:
- 1. Credit Card Debt
- 2. Automobile Debt
- 3. Student Loan Debt
- 4. Mortgage Debt
For your pleasure, we listed them in order from worst to not as bad. Credit card debt will have the highest interest rates. Automobile debt will have semi-high interest rates and will heavily increase the cost of your insurance. Your car also steadily decreases in value over time. Student loans have varying interest rates and usually, are a substantial amount. Mortgage loans rate depend on time, will take many years to pay off, and may end up costing more than the property is worth.
“Debt is the devil.”Wealthy Whisper
To become wealthy and financially free, you must eliminate debt and stay out of debt. Take the time to create your budget and start today on eliminating debt. Once the debt is gone, don’t let it come back. All the money you had in your budget for debt can become money for investing. Eventually, you will turn your liabilities into assets. That is where financial happiness becomes a reality and dreams come true.