Debt comes in many flavors: student loans, mortgages, credit card debt, car loans, etc. I talk a lot about how to invest when you’re debt free like me, but the reality is that I’m extremely lucky and a minority in modern day financial culture. I like to think of money like water; it can allow you to float, but you can also drown in it. When you are overloaded by debt, it can be easy to feel like you’re drowning and completely out of control. I’d like to provide whatever advice I can to help you start treading water, and someday even build a boat to float on.
First of all, debt is not a magical entity. It’s money you owe so you can have something you haven’t earned yet financially. That may sound condescending, and when it comes to a college education or a reasonable car (Camry = reasonable, Bentley = unreasonable), it’s not meant to be, you need those things to survive in our modern culture. The reason why I say it’s not magical is because there are very logical and real ways to make your way out of debt. So, here we go.
Don’t be too proud
Before you can get to work on your debt, you need to understand if your current lifestyle is sustainable. To do this, you’ll need to do a cash flow analysis on your monthly income and expenses. If you’re making more money than you’re spending, jump to the next step. If you’re losing money, it’s time to find some help. If you were drowning, would you be too proud to grab the hand of someone sitting in their cozy boat? You need to accept that your lifestyle is more lavish than you financially deserve. Stop eating out as much and learn to cook. Consider moving in with roommates or even your parents. The first step is to get your cash flow into positive territory.
Build a cushion
Before you start paying anything off, you’ll want to save about $1000 so that you have a cushion for your expenses each month. You can also do this as part of your budgeting exercise in the previous step. This step will help remove some of the paycheck to paycheck stress that might cloud your judgement.
The Debt Snowball
Credit for this technique belongs to Dave Ramsey. How this works is you find out which of your debts has the lowest balance. You will make the minimum payment on all of your debts except for that one. All of your extra cash each month should go towards paying off the debt with the lowest balance. Once you have that first one paid off, you can use the money that would have gone towards that account to pay off the next lowest balance. With each debt you pay off, you build momentum like a snowball falling down a hill.
Interest Rate Balancing
Here’s an example. You owe $200,000 for a mortgage with a 4% APR on a 30 year term. You have $1000 each month with which you pay your mortgage minimum payment, and with the remainder you can either invest at an average yearly return of 7%, or use to pay off your mortgage faster. After 30 years, either way you will have your mortgage paid off, however, if you paid it off more quickly, and then invested all of the extra money afterwards, you’d have an investment balance of $31,681. If instead, you invested the extra money, making only the minimum payments, you’d end up with $55,426. So by investing early, you end up with $23,745 more than by paying off your mortgage faster.
Additionally, money you invest is more liquid than money that goes towards debt. Even though this strategy may seem controversial, it may be in your best interest. If you’re new to investing and aren’t confident that you can get a good enough return, don’t risk it. You should always consider your personal situation before adopting a financial plan from someone else.
How about you, are you underwater or floating? What’s your take on paying off debt early or investing extra capital?