What would your life be like if you held no debt? I’m not talking about just paying off short-term debt like credit cards, medical bills, or student loans. I’m talking about all your debt, including your mortgage. What would that freedom allow you do?
The rich rules over the poor, and the borrower is the slave of the lender. Proverbs 22:7
In my opinion there are three main types of debt: Atrocious Debt, Bad Debt, and Wealth Building Debt.
Credit Card Debt
Credit card debt is an example of “atrocious debt”. I believe credit card debt is also the most pervasive form of this type of debt. The average household that carries credit card debt has accumulated roughly $16,000 in debt (Credit Card Debt). According to this post by Jason Cabler, it will take almost 31 years by making the minimum monthly payment of $320 to pay off this debt. This means that you will end up paying basically double $33,522, for the stuff you bought.
I know many people have used a credit card in an emergency that was unforeseen. I get that; it happens. But, we need to break this cycle of getting out of debt only to get back into debt when the next emergency comes. I don’t know about you, but every year an unexpected expense arrives that I don’t anticipate. I would encourage you once you paid off your credit card debt to have six months worth of living expenses to avoid a similar emergencies. I believe that to be a good rule of thumb.
Car loans are an example of “bad debt”. Some people want a brand new car because they believe it will be dependable and reliable since it is new. When is the last time that you or a friend sold a car for a profit? If you said never, it’s because cars generally are depreciating asset (Edmunds). Is it really worth buying a car that loses almost 10% of it’s value the minute it leaves the dealership lot? One year later, it has lost almost 20%, and by year four, it has dropped to almost 50% of its value. Because of this, I would recommend buying a used car that is at least four years old. This will allow you to still buy a fairly new car for nearly half the price. With that said, I understand that some people place more value on their cars and are willing to pay a premium for them; however, I, for one, am not one of them.
Is All Debt Bad?
“Wealth Building debt” encompasses debts that should theoretically help you in the long run. Now is all debt bad? Some experts will say not necessarily, but in my opinion, debt hinders true financial freedom and all the goodness that that entails. Unless the debt is helping you achieve something that you are truly passionate about and will bolster your goals, it can be a drain on your finances. A student loan, for example, is a type of debt that allows you to invest in yourself.
In my opinion, YOU are the greatest appreciating asset. Research has shown that the higher the education, the higher the employment rate and the greater the earning potential. According to this College Graduates study in 2011, college graduates earn 84% more money than high school graduates. You will not ever see me get upset with people that have a plan on how their education will enhance their careers and lives. It’s debatable whether or not it makes more sense to take on student loan debt by going to an out-of-state school versus the local community college or public state school. Most of the research done around this shows the return on investment for public schools is higher than a private school, but if you get into an Ivy League school, the connections that you make there can definitely help you over a lifetime.
So, let’s say that you have accumulated some student loan debt. Some folks with student loans hesitate to pay them off because these loans are tax-deductible. In actuality, this is a common misconception that these loans are tax-deductible, dollar for dollar, against one’s final tax bill. In fact, if you make more than $75,000 adjusted gross income as a single individual (or $155,000 as a married individual), these loans cannot be tax deductible (IRS). Furthermore, let’s say that you paid $1,000 of student interest for the year. In addition, let’s say that you are currently in the 25% tax bracket. This means that of the $1,000, you only get a benefit of $250. Therefore, in reality, your final tax bill would only decrease by $250, and there would be no taxable benefit on the remaining $750. Is it really worth paying an extra $1,000 to receive $250 back?
Mortgages are another example of “Wealth Building debt”. Today, mortgages are pretty much a necessary evil to afford a home. With housing prices averaging $272,000 (Home Price) and the wage of the median household making $50,000 (Household Income), it is nearly impossible for an average family to pay for a house without incurring some type of mortgage.
Since most of us will have to utilize a mortgage to pay for a house, I would encourage the selection of a 15-year or even 10-year mortgage, if possible, instead of the traditional 30-year mortgage. While the payment may be slightly higher, you would potentially be out of debt in half to two-thirds as fast, allowing you the freedom to pursue things that bring greater joy than paying mortgage bills each month. On a $200,000 loan at 4.5%, a 30-year loan would have you make a month payment of $1,013 and in turn pay in excess of $164,000 interest. As a comparison, a 15-year loan would have you make a monthly payment of $1,529 and allow you to pay less than half of the amount of interest at $75,000. While the payment is 50% more, you would be able to not only pay off the mortgage faster, but the difference that you would pay in interest is more than double. This is a great deal if you can afford it.
Now that we’ve expounded about the three types of debt, how can we eliminate debt? There are two main ways of knocking out the debt.
Financial author and speaker Dave Ramsey advocates this method. It involves paying off your smallest debt first. So, you would continue to make the minimum payments for all of your other debt and also apply any extra money towards the smallest debt. Once you have paid off the smallest debt, the freed up money can be applied to the next smallest debt and so on, until you have paid off all of your debt. This is the preferred methodology as the psychology shows that most people are likely to follow through with this plan in order to get out of debt.
Interest Rate Prioritization
The second method is determining which debt has the highest interest rates. Once you pay off the debt with the highest interest rate, then you then apply the extra cash to the debt with the next highest interest rate until you have paid off all of your debt.
There are pros and cons to each of these methods. The first method involves the psychological benefit of small wins that a debtor gets from paying off each debt. While it may take longer to pay off all of the debt, knowing that you have “won,” by paying off previous smaller debts, helps you to stay motivated to continue paying off other debts. The second method should help you pay off the debt faster since you are paying less in interest; however, some people become discouraged when they do not see their balance go down as fast. Determining which method would be most effective is really an individual choice.
Are you in debt? Do you have a plan to get out of debt, or are you just trying to stay above water? Share your thoughts below.