Dealing with debt is an important for financial security.
Now, we turn our attention to debt. If you have no debts, good on you! Please continue to read on because there where the decision to go into debt may arise. If you have debt, then freedom from it will become your priority.
Debt costs you not only financially, but the idea of owing money can cost you psychologically as well.
Getting out of Debt
There are two methods to tackle debt:
- Avalanche method: the most logical and money-saving tactic. Repay the debt with the highest bearing interest first.
- Snowball method: the most motivating and easiest to maintain. Repay the smallest debt first.
Let’s look at an example. You have the following debts:
- $5,000 credit card debt at 20.95% interest
- $1,000 overdraft at 10.00%
- $10,000 car loan at 6.50%
- $20,000 student loan at no interest
On our spreadsheet, we are going to create a new tab to organise our debts.
When entering the interest rates in, make sure you enter the percentage (%) sign for the following formula to work.
Next, we want to work out the interest per annum (or year). The interest is what is costing us financially. We can do this by multiplying the interest rate (as a percentage) with the principle of the loan (the size of the loan).
The we can work out the rough weekly cost by dividing by 52.
Here is the entire table of our loans.
If we take the avalanche approach, we will aim to pay off the highest interest first, while paying the minimum required for all our other loans. This is the credit card loan. In the snowball method, on the other hand, we make paying off the smallest loan first as the priority. This would be the overdraft.
Logically, the avalanche method may save us the most money, but life is never always logical. We might concede paying off the credit card loan as it will take longer. Eliminating debt sooner is more motivating. If you are struggling to stay on track, then the snowball method will work better for you.
Personal finance is personal. The method you choose will depend on you: if saving money is able to keep you going or if you need the satisfaction of slicing smaller loans first. The key is to contribute at least something so you can get our of debt as fast as possible.
But what do we pay the debts off with?
Remember the leftover money from your budget you made earlier? You are going to devote this to demolishing your debts. Your emergency fund should be plenty to cover any future mishaps, so we won’t focus on putting money there. We will stay away from saving until these debts are gone.
As an aside: you might see the student loan (or studen loan. It’s an abbreviation, not a typo. I swear!) of $20,000 and thinking what to do about that. Since this loan has no interest, then we want to pay it off as slow as possible. Sam Harith and I go into more detail about student loans in a recent collaboration post.
Debt consolidation is another tactic you can employ to make paying off debt a bit more simple. All debts are combined together into one simple loan. Often, the loan will have a smaller interest rate. On the other hand, you must remember the loan will be larger and you must be sure you can make the repayments.
When debt is acceptable
Debt costs you money and your mind. So, how can debt be acceptable?
Well, my young padawan, “Only a Sith deals in absolutes.” A heartbroken Obi-Wan1 would tell you there are always exceptions to every rule.
Debt is acceptable in three situations:
- Education is an investment in yourself. The most important asset is not your flash phone, car, or house even; it’s you. More specifically, it is your ability to earn an income. The right education opens the door to jobs that can enable you to earn more. A bonus in New Zealand is there is no interest on student loans as long as you stay in the country after graduating. There is a flip side. Education that leads to no job can end up costing you a lot.
- Home-ownership is an asset that increases in value over time. A home also provides you shelter. A fully paid home reduces the amount you need to retire in the future, as you won’t need to pay rent anymore. Once again, the right home will improve your financial security versus the wrong one.
- A business gives you the opportunity to optimise your time instead of trading it in for money. Owning a business is risky… business but also very rewarding if it proves successful.
Once again personal finance is personal. Even with the above exceptions for debt, you really have to weigh up if the rewards are worth the risk.
Avoid these debt situations
If your reason to go into debt is not in the above list of three acceptable situations, then it’s not a good reason. What was common about those previous scenarios is that those options involve an investment. An investment increases in value over time. This value can far outweigh the initial debt.
The problem comes when your purchase something that does not increase in value. This costs you more than if you were you pay in cash.
Let’s run through some examples:
- Car. A mode of transport. It gets you to work and from work. It’s needed so you can make money, right? As soon as you drive that car out of the dealership, it will drop in value significantly. When you drive your car, it will slowly decrease in value. Even having your beloved gas-guzzling beast sitting in the garage will drop in its worth over time. This is known as depreciation. You are better paying for a second-hand car in full, rather than paying interest on top of a car loan and also losing out on depreciation.
- Holidays. Working hard or hardly work? Either way, you need a break. Don’t go putting that expensive hotel stay on a credit card and expect to pay it back after you return. Holidays are supposed to leave you feeling refreshed, not leave you with nagging interest from the credit card bills once the holiday blues set in.
- Expensive items. Pay cash for any items like television, phone, laptop. Going into credit, even if there is an interest-free period, creates terrible habits. All this does is inflate your lifestyle, costing you more later on. Buying on credit, only increases your craving for more novelty. Delay your gratification and save up for whatever you need. You will be more satisfied with your purchase.
- Debt to invest. Other names include gearing or leveraging. This involves taking cash from a loan and investing it. All this does is increase risk. It can either go really well or really badly. Investing in a home since it provides you with shelter and reducing living expenses when it is finally paid off. For a business, this can improve your working situation as well as improving your skills as a leader. If you were you to put money into the stock market or index fund, you should do this regularly with cash from your paycheck after you have paid your debts and made defined financial goals.
- Emergencies. This is why you have an emergency fund. If you do dip into it, make sure you stock it up as fast as possible.
You know what I’m going to say. Personal finance is… You might desperately need a car for work. If you do decide to get into debt for the above purchases, then please make it your priority to get out of debt and avoid these situations.
Getting out of debt is a requirement for financial security. Debt costs you more money. The stress of bills can cost you psychologically as well.
If you have debts, then prioritise becoming debt-free. This can be done in two ways. The avalanche method focuses on the highest interesting debt first, saving you the most money. The snowball method focuses on the smallest debts first, being more motivating.
In most cases, if have no debts, then it is a good idea to stay debt-free. However, there will be situations where debt is acceptable. This includes taking a loan to better your education, buying a home, or building a business.
Avoiding debt in any other case. This includes purchasing a car, going on holiday, buying any expensive items, and even investing. These options cost you more, give you bad habits, and make your life riskier.
Your finances are a thumbprint. Everyone’s unique. Debt appears like a large mountain to climb, but you will make it to the top if you take the first step today. I hope you find this post useful. Please share this with others if it will help them out. If I missed anything, please comment below. Also, sign up for my newsletter to stay updated if you found this useful.
Good luck on your path to financial security!
Finally, as a disclaimer, I am not a financial expert or professional. This post is for educational purposes only. A lot of what is on here is anecdotal and I would advise you to perform your own research or seek a financial professional.References
- From Star Wars Episode III: Revenge of the Sith. Obi-Wan confronts his friend and former apprentice Anakin Skywalker, now Darth Vader.