I am usually not keen on writing purely personal finance related posts, but I was reading an article titled “How to get out of debt through smart financial planning” which inspired me to journal my thoughts on getting out of debt.
I am not a debt consolidator, or an expert on the subject matter by any means. I do however consider myself a financially savvy and responsible citizen. Take my thoughts with a grain of salt if needed, and please correct any confusion or misunderstanding this article may cause.
To me debt is synonymous with disease, a slow and painful process that can eat you up to your ruin – if you don’t do anything about it at least. I have seen the healthiest individuals and families shatter into pieces because of debt. Whenever But despite that, I HAVE debt!
Not all debt is bad debt in my opinion. The right kind of debt can be used to your advantage. How? With a good understanding of what debt is and the kinds of debt, you can leverage debt to your advantage when you identify the right opportunity.
Everyone wants to get ahead in life but many find themselves stuck in the same spot they were in years ago. Many want to move on and plan for their retirement but instead they blame their situation and the lack of taking any action on being drowned down in debt and not being able to get out of it.
To be able to plan for retirement, one must eliminate or minimize their debt as much as possible. Common sense? It does not make sense planning for the future when the present isn’t as stable as it should be does it? The stress will probably kill them anyway before they voluntarily and formally “retire”.
Merriam Webster defines debt as follows:
1) sin, trespass
2) something owed : obligation <unable to pay off his debts>
3) a state of owing <deeply in debt>
4) the common-law action for the recovery of money held to be due
To me debt is money you borrow now to satisfy a short term financial acquisition (often times a want and not a need) and pay for it for months and years to come.
Not only do you pay the principal back (the original amount borrowed) but you also pay an interest charge as a premium to use someone else’s money. Professionals call it the cost of capital, or cost of borrowing.
A $150,000 loan to buy a single-family home at a 7% interest rate will cost you almost $10,500 in interest payments alone in the first year you carry the debt. A 30 year calculation is rather scary.
There are two general types of debt: bad debt & good debt. I refer to bad debt as consumer debt.
Consumer debt includes but is not limited to credit card bills, mortgage payments on your home, personal/recreational loans, car payments and leases, boat installments and the likes.
Good debt is investment debt. With good debt, you do not pay the service charges. Instead, you are being paid to carry debt on your books.
Good debt is investment debt. It is debt used to purchase assets that generate positive cash flow for you. For example, if you take out a $60,000 loan to purchase an undervalued rental property that is valued at $100,000 and charge market value rent, chances are that your rent payments will exceed your loan payments, thereby creating free or positive cash flow. I don’t recommend getting out of debt that is good, at least not unless you have no better use for the funds.
There are also other tax advantages of owning a rental property such as depreciation and certain business expense deductions to mention a couple. The tax benefit from these should also be factored into your overall return.
Again, I am not an expert on this topic by any means. Over the years of “consulting”, really helping others through volunteer speaking engagements, support groups and such, I have found the following to work. Most of it is common sense.
One thing you can do to expedite getting out of debt or to stop piling up more is to stop taking credit on your lender’s terms for consumption items. Consumption items refer to items for your personal use such as your home, car, boat, new clothes etc.
I understand that not everyone has money sitting around to buy a house or a car with. However, when you’re in debt, over indulging in consumption items, although it may seem like a necessity to you, is a poor decision. To me, purchasing a 3,000 square foot home when all you need is 1,500 is over indulging. Also, the lower your credit score, the higher your payments will be on all of your debt. Speaking with a specialist to learn the tips for a fast credit fix and getting out of debt sooner certainly helps in this case..
Instead of taking a loan out for the purchase of a new car or a brand new home, focus on saving money by settling for an older, used car and renting until you get out of debt. This particularly works well in deflationary times like today. As a landlord, I am feeling the downward pressure on rents.
The bottom line that any basic finance book will tell you is that you need to keep your consumption purchases at a minimum while getting out of debt. The money you save from cutting back on consumption can be used to pay down your obligations faster. Either that or find a way to make more money, which I hope this blog is helping you with.
The second step I recommend is to establish a concrete plan of action on paying down debt. I usually recommend putting away at least 10% of your gross income in savings. Before you begin put money away however, you need to get out of debt.
Take that 10% of your income and earmark it to pay down your debts. Add to this the money you save from not engaging in excessive consumption and you should have a relatively good sum of money to pay down your debts with monthly.
The only exception to this is putting money away in a defined contribution plan like a 401(k) that your employer offers. Not taking advantage of an employer contribution match to a 401(k) or similar plan is simply foolish. At the least, contribute up to the point your employer matches your contribution. This is one of the rarest exceptions when I recommend puting getting out of debt on the back burner.
Third, take an inventory of your existing debt and determine what you owe and your monthly payment to each creditor. Once you have taken stock of your current debt situation, determine your “payoff ratio”.
The payoff ratio refers to the time it will take to pay-off your debt by sending in just the minimal payment amount. Do this for each vendor you owe money to. Taking stock of your obligations alone will help you understand what you owe and expedite the process of getting out of debt.
Fourth, determine your payoff priority. Payoff priority refers to debt with high interest rates vs. debts with low interest rates. Common logic would indicate paying off the high interest debt first.
Often times, creditors become negotiable when they realize that you are having difficulty paying down the debt. However, they won’t know this until you tell them or show signs.
Take the time and communicate your situation to them. With a genuine reason and desire to pay down your debt, the creditors will be willing to negotiate in most cases.
I have heard interest rates reduced, and sometimes even frozen for some people. I have also heard reduction in overall payment owed through a one-time settlement offer. One must really be deep down in debt for this to happen however.
Fifth and finally, take the debt with the lowest payoff ratio (which is simply the amount owed divided by the minimum payment) and use the disposable cash you have from step 2 to pay down this debt.
Do not worry about other debt accruing interest in the mean time. You will soon be done paying off this debt in its entirety if you use all your spare cash to pay-off just one debt. Once this debt is paid off, continue paying off the debt with the second lowest payoff ratio.
Keep doing this until all your debt is paid off. When you are done paying off your debt, you will be left with a good amount of spare cash at the end of each month (the same cash that you used to pay off debts with) to fulfill your consumption desires.
It is about this time when people celebrate and treat themselves for such a big achievement. Rightfully so! Proceed with caution. You don’t want to celebrate your way into the same mess that you were in to begin with.
The real game starts right about the time you become debt free. You can now begin to think about savings, retirement, travel, or doing all of those things you had put on the back burner. Understand that getting out of debt is not the end all, rather it is just the beginning to a life of financial abundance and peace of mind.
Ironic as it is, some of the toughest challenges we face require the simplest solutions to be implemented. The key however is execution, as it is with most things in life. With a sound approach and disciplined practical application, most difficulties in life can be overcome over time.
Many have become debt free by following this simple common sense plan. All it takes is some organization and discipline. No one will look after your financial success as much as you will – and it all starts by becoming debt free in my opinion.
I know a few in their 20s and many in their 30s who have become free and clear owners of their homes just a few years after having purchased it. Can you imagine the surplus of free cash flow at their disposal?
These folks are using the cash to save, invest, start a small businesses, buy more properties and spend in all kinds of ways, many of which I can’t even imagine. The point is that they have options, and options are usually good. Getting out of debt will give you those very same options.
I also know a few others who have chosen to consolidate their debt. I have never had to do this, and don’t know much about the topic in order to speak intelligently about it.
But I do know that consolidation is also an option for someone with excessive number of creditors. That said, make sure you research the pros and cons of debt consolidation in greater detail before making any moves, and then come back and educate me about it 🙂
Don’t even think about it. It is common for people to advise you to file bankruptcy when times get tough and all the debt piles up. Many people are advised to file bankruptcy because this is the easy way out.
But like debt consolidation, I recommend you research the pros and cons of filing for bankruptcy before making a move. There is plenty of good and free material online to educate you on the topic. I don’t think Bankruptcy is the best solution to getting out of debt.
That said, there is a point when bankruptcy starts to make sense. After all, certain assets such as retirement funds and your domicile home (in certain states) cannot be seized under court protection. But like I said, look into the pros and cons thoroughly. For as big a step as this in your life, I’d hire a lawyer who knows what they are doing.
If you are not bad debt free yet, close your eyes for a half a minute and imagine yourself debt free! Can you imagine how life would be? Debt reduction helps your FICO score, and a better FICO score can open doors to unlimited possibilities for you in the future.
Are you debt free? Do you plan to be? If so, in how long? What additional tips and suggestions do you have for our readers to expedite getting out of debt?
Read how getting out of debt fits in with my recipe for a healthy financial life here.Previous: What is the American Dream?