Personal Finance Step 4: Eliminate Your Debt
Hello everyone! I would like to take a moment to welcome myself back to America and real life. Brent and I just went on our delayed honeymoon and spent two weeks in The Philippines with an extended layover in Hong Kong. Expect a trip report on that excursion soon!
This is the fourth installment in our Personal Finance 101 Series and it is a fun one - DEBT!
I must first admit that I am not an expert on getting out of debt, I am a pro at avoiding it like the plague. My dad’s first words to me were “what are the only two types of debt that are acceptable to carry?” My small infant self shouted back “a home mortgage and student loans because they are appreciating assets!” Seriously, I distinctly remember this exchange in the hospital before they brought me home.
I have lived in mortal fear of debt ever since and I am very glad of it. Debt is the opposite of freedom. You don’t have a choice where you money goes, you have to pay off your debt. It is always knocking on your door and always looming over your head. At least that’s how it appears in my nightmares and conversations with some friends who have credit card debt tell me I am right.
If you are interested enough in getting your financial house in order to read this post, I don’t think I need to convince you that getting out of debt is something that you want to do. In case you are still wondering why debt is so bad, please read this excellent post by the MMM himself.
Read it? Good. Now that you are convinced that debt is the devil, we need to talk about the practical steps you can take to get out from under it. First, let’s talk about why your home mortgage and student debt loans CAN be okay debt to take on.
LET’S TALK ABOUT MORTGAGES
You have to pay for housing no matter what. And in certain circumstances, it makes sense to pay a mortgage instead of rent so that you are building some equity in your home and can eventually pay off the mortgage and not have to pay rent. Home ownership can be a good idea if you know where you want to live for at least the next 5 years, and you buy a house that is less expensive than what you can “afford” according to the bank so that you know you will never have a problem making your mortgage payment. The reason it’s okay to borrow money to buy a house, but not a car, is a little complicated, so bear with me.
Let’s say a home in your area in your price range is $300,000. If you wanted to buy a house and not take out a loan, you would have to save and save in cash until you had over $300,000… in cash. This would likely take you a very long time. While you are saving, your money is sitting there in the bank loosing value to inflation (aka things you buy are getting more expensive while you money amount stays the same), and that house is also likely getting more expensive in the years you take to save 300k in cash. You are also missing out on the gains you could get in the stock market if instead of keeping those thousands of dollars in cash, you invested them. This is called an opportunity cost. If we take average stock market returns of 7-8% over the many years you take to save that much cash, you are missing out on a lot of gains that your money could have made for you. Importantly, those gains should be higher than the interest rate on the loan you would have gotten to buy the house. Say your interest rate is 4% so you are paying 4% on 300k to buy and live in your house, but you are able to take all the money you would have had to save in cash to buy your house and put it in the stock market which is making an 8% return. You come out ahead by borrowing money at a low interest rate to get your house, and investing money you otherwise would have had to funnel to they house which earns 8%. Meanwhile, your house is hopefully appreciating in value (or at least staying the same) so your net worth is growing in that way as well. Importantly, that means that if you ever needed to get out from under your mortgage due to a change in circumstances, you could sell your house and cover the loan amount and walk away. You cannot do this with any other property. Cars, boats, clothes, and hoes. They all depreciate which means they loose value as they get older. So even if you needed to get rid of your loan, you can sell the car and walk away because the car is worth far less than the loan amount you owe for it.
LET’S TALK ABOUT STUDENT DEBT
Student debt, like a mortgage, is a loan that CAN be acceptable to take on because you investing in what you hope is an appreciating asset: yourself. The idea is that higher education increases your earning prospects over your lifetime, so paying the tuition and interest payments on the loan is worth it because you will increase your income by an amount much greater than what you have to pay. For me growing up, not going to college wasn’t an option. It was expected and pretty much the only life course presented to me. I think that is how a lot of us grew up. I was incredibly fortunate that through a combination of scholarships and a college fund from my grandparents, I graduated both undergrad and law school without taking on any debt.
Due to my lack of experience on the subject, I will share my husband’s story with student debt. He graduated from a public university with a degree in mechanical engineering and did so without financial help from his family. He worked multiple jobs all through college to pay for living expenses and minimize the amount of loans he had to take out. He graduated with 34k in debt and no job. He went on a wild west roadtrip from Virginia to the Pacific Northwest and then to Colorado because he had visited Denver once while in college and decided he wanted to live there. He got a job working construction and did that for 9 months until he found a job, which was actually a paid internship, in engineering. 6 months after that, the company was struggling and laid off Brent with most of his coworkers. His boss told him he could go work “in the field” for a few months if he wanted to. So Brent packed his merry bags and headed off to Northern California to work in prisons installing security systems. After two months of living in a house with other transient field workers and a bad case of bed bugs, he came back to Colorado and collected unemployment insurance for 2 months before he found the job he has now been at for 3 years in electronics/application engineering (not what he went to school for or what he wanted to do). Brent is now 2 years out of school and has not had the immediate high-paying career that he was promised when he went into engineering. His career path was bumpy at best and he didn’t make even close to over 50k a year until he landed his current position. Even so, he was paying off his student loan debt that entire time. He received an inheritance of 17k the summer 2 years after he graduated and put the entirety of that amount toward his student loans. Six months later, 2.5 years after graduation, Brent paid off the entire balance of his student loans and was debt free. Nice work kiddo!
Your student loan may have a low interest rate, but I highly recommend you tackle it and take it out like it was consumer debt (unlike a mortgage which can make sense to keep around). Eliminating reoccurring monthly expenses like loan payments is absolutely crucial to actually being in control of your money.
Most importantly, don’t ignore your debt. Let’s talk about how to really take on your debt and eliminate it from your life. It’s simple in that it is just math. You just have to really commit to it.
ELIMINATE YOUR CONSUMER DEBT
Consumer debt is all debt other than the two “acceptable” types of debt we detailed above (mortgage and student loans). Yes that includes the car loan everyone assures you is normal to have. If you can’t pay for it IN CASH TODAY without sacrificing any financial goals, then you can’t afford it. Live by that rule and you will never take on personal debt. Our previous posts on personal finance have really been leading to this point.
In Step One you calculated your net worth, which means you know if you are in debt and, if so, how much.
In Step Two we cut all possible expenses from you life to give you money some breathing room. You now have extra money each month.
In Step Three, you took that extra money to build an emergency fund of at least $1,000 right away building up to 3-6 months of living expenses.
And now in Step Four we are allocating that extra money also to paying off you debt.
The first thing you need to do is figure out exactly how much you owe on each of your loans. I really recommend actually printing out the loan balances to make it tangible. On a separate paper for each account have: (1) the entire amount due, (2) the interest rate, (3) the minimum monthly payment. Add together all of the minimum monthly payments. This is the amount you know you have to pay each month. Now go back to your monthly budget and see how much your income exceeds your expenses - in other words, how much extra money you have each month after paying the things you need to other than these loans. If your extra money is less than or about equal to the sum of all you minimum payments, go back to Step 2 because you need to cut more expenses from your life. You should also look for ways to increase your income like a side hustle (I walk dogs for an extra $40 a week). This is non-negotiable. You must be able to pay your monthly minimums or you are just going deeper into debt.
Okay, lets say you have $500 of “extra” money each month and your minimum payment sum is $350/month. You have $150 of water to throw on the fire of your debt! This is great!
Now, arrange those papers in two ways.
First, by interest rate, highest to lowest. Write down the order.
Second, by loan balance amount, lowest amount to highest. Write down the order.
The debt with the highest interest rate is the most expensive loan you have, they are charging you the most to loan you money. I recommend that you throw your extra $150 dollars per month all at that most expensive debt until it is gone. Then move on to your next most expensive debt and keep going down the line until you are debt free. Now, remember, you have to keep making the minimum payments on all of your debts while you are throwing your $150 at one of the loans.
If you are having a hard time motivating to pay off your debt, or feel like it is too big of a task and is impossible, paying off your smallest debt first might be a good motivator. Once you pay off that debt, you have freed up your $150 to throw at another loan AND the minimum payment that you were paying on that first loan so you will have even more water to throw on the fire! Once you get some encouragement by paying off a loan, I really recommend paying off your most expensive loans first then.
If you are in debt, you need to be dramatic about paying it off. It is your number one priority after you have a sufficient emergency fund that will keep you from having to take on more debt. This is not a quick fix and likely will require a lifestyle overhaul. Your current way of living is what got you in debt (student loans aside) so you will absolutely have to change the way you live if you want to get out from under your debt. Here’s the thing about how to get out of debt, it’s a lot like how to lose weight. We all know that we have to eat healthy foods in quantities lower than we are currently eating and workout at levels higher than we are currently working out. That’s just math. Likewise, there is no secret to getting out of debt. You have to spend less than you currently are and throw that extra money toward paying off your loans. Even though both concepts are “simple,” there are multi-million dollar industries around how to do both. Don’t get overwhelmed and don’t ignore it. Spend less and pay it off.
You will buy used cars, in cash. You will have a roommate. You won’t go to the concert. You won’t go shopping when you are bored. But you will be free.
Please let me know if you have any questions by dropping a comment or sending me a message! You can do it!