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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?
Simply put: I hate debt.
Proverbs 22:7 says, “The borrower is slave to the lender.” I couldn’t agree more. Once you are in debt, you may fall into a perpetual cycle of accumulating deeper debt. The more debt, the less freedom. It can even cause major health issues.
Did you know that you those with high debt are:
- 3x as likely to have had ulcers or digestive tract problems, compared with low levels of debt stress.
- 3x as likely to have migraines or other headaches.
- More than 7x more likely to suffer severe anxiety.
- Almost 6x more likely to have had severe depression.
- 2x more likely to experience a heart attack.
Debt can clearly do terrible things to your body. On top of that, debt can also wreak havoc on your marriage. Survey results show that 70% of couples argue more about money than other relationship busters like quality time, household chores, pet peeves, and even their in-laws.
So what exactly are these financial fights all about?
Most married couples cite frivolous purchases, household budgeting, and credit card debt as the biggest sources of friction.
I believe there are two main types of debt: Instant Gratification Debt and Wealth Building Debt. I will go into detail about each and then provide you ways to get out of debt as efficiently as possible.
Instant Gratification Debt
This is any debt that is related to purchases that quickly met your wants and desires. Even though it gratifies you in the moment, it can cripple you in the future. Credit card debt is the most pervasive form of instant gratification debt.
Credit Card Debt
The average household that carries credit card debt has accumulated roughly $16,000 in debt.
According to Jason Cabler, it will take almost 31 years by making the minimum monthly payment of $320 to pay off the average American’s credit card debt. This means that you will end up paying basically double ($33,522), for the items you bought.
So the question that you have to ask yourself if you’re paying the minimum payment is, are the items bought really worth double the price you paid for them?
Some people get into credit card debt, not by buying too much stuff, but because of an unforeseen emergency.
I get it. Things happen.
But, it doesn’t make this type of debt any less harmful. 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 about every year, some sort of unexpected expense arrives for me.
Once you pay off your credit card debt, it is ideal to have 3-6 months worth of living expenses saved to ensure that future emergencies won’t cause you to go back into debt.
So why do all the of the experts say you should have 3-6 months of expenses?
According the latest from the Bureau of Labor Statistics, someone who is currently unemployed on average, needs over 3 months to find work.
But guess what? In 2010, after the Great Recession hit and the US economy was still climbing out of it, the average unemployed individual remained unemployed for about 25.2 weeks, or almost 6 months.
Another form of instant gratification debt is money spent on depreciating assets. A depreciating asset is one that loses money over time. Car loans are a prime example.
When is the last time that you sold a car for a profit? If you answer, “Never”, it’s because cars generally are a depreciating asset (Edmunds). Did you know that after buying a brand-new car, that it loses almost 10% of its value the minute it leaves the dealership lot? One year later, it has lost almost 20%. 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 4 years old. This will allow you to still buy a fairly new car for nearly half the price.
I see so many people living beyond their means, driving fancy cars that carry huge car notes. But do you know what the best selling vehicle among rich person (with an income over $200,000) was? A Ford F150. Not a Mercedes, not a BMW, not a Tesla.
Interestingly enough, the #5 best-selling car among wealth people was a Honda Civic. So if you are trying to emulate the wise and wealthy, maybe you should gravitate towards the more affordable, more reliable cars versus the luxury ones with astronomical price tags.
So Is All Debt Bad?
Yes and No.
There are arguments on both sides of the table. Some financial experts say that debt can be used as a tool to further one’s financial standing. I, on the other hand, tend to still disagree. I think debt is too much of a slippery, dangerous slope. It hinders true financial freedom and all the goodness that that entails. So in my book, debt is something that should be always avoided if possible.
Wealth Building Debt
This type of debt should theoretically help you in the long run. It should bolster your goals. 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.
But should you take on student loan debt and attend an out-of-state school versus a local community college or public in-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 will supposedly benefit you over a lifetime.
Student Loan Debt
So, let’s say that you have accumulated some student loan debt. Some with student loans hesitate to pay them off because they believe 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 can be a necessary evil to afford a home. With housing prices averaging $272,000 and the wage of the median household making $50,000, 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 require a monthly payment of $1,013 and in excess of $164,000 interest.
As a comparison, a 15-year loan would require 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.
There are two main ways of knocking out the debt.
The Debt Escalator involves listing out all your debts from lowest balance to highest balance. You would then continue to make the minimum payments for all of your debt and then apply any extra money towards the smallest debt. You would continue to do this until you have paid off the smallest debt.
The freed up money from the extinguished balance can then be applied to the next smallest debt and so on, until you have paid off all of your debt. And you slowly go up the moving escalator.
The psychology shows that most people are more likely to follow through with the Debt Escalator plan due to the nature of “quick wins”. Each time you see an account paid off in full, there is a feeling of accomplishment that boosts our self-esteem, and you are able to take the next step upward towards paying off the next debt. In turn, we really believe that we can really follow through with these plans because each step brings you closer to the top.
Debt Elevator (Interest Rate Prioritization)
The Debt Elevator starts at tackling the debts with the highest interest rates first. Psychology aside, this way is the preferred method of debt elimination. But it does take some discipline and diligence.
Once you pay off the debt with the highest interest rate, you would then apply the extra cash to the debt with the next highest interest rate until you have paid off all of your debt. Much like an elevator, you drop from floor to floor fairly rapidly.
Which to Choose?
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, the “wins” experienced in the Debt Escalator may help 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.
But just as a caveat, in a 2012 study by Northwestern’s Kellogg School of Management, researchers found that “consumers who tackle small balances first were likelier to eliminate their overall debt”.
Paying Down Debt
A common question I receive is, should I stop contributing to my 401k, which includes an employer match, in order to focus on paying off debt?
My answer is MAYBE.
If you have debt interest rate balances over 8%, stop making contributions into your 401k until you have annihilated all of your debt over 8%. Once your debt is under 8%, start contributing to your 401k again while still continuing to paying off your debt.
Why 8%? It’s because this is what the stock market has returned on an annual basis since 1926. Makes sense, doesn’t it?