How To Tackle Your Debt Properly

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In my last post I wrote about how much I hate debt. If you can avoid it, then do so at all costs. There is nothing worse than having the bank, or whomever you owe money to, suck your money away from you on a monthly basis.

Debt is an instrument used to get ahead now, but inevitably it drags you down in the future. If you think about a timeline, debt is just a way to borrow from your future self. Interest is the penalty that you pay to get what you want now, without actually having the means. It’s the interest payments that really hurt the most, because that is the cost of having the loan. That’s the thing that eats away at your monthly cash flow.

Remember that cash flow is the most important thing. It’s not about how much you make, or how much you have in the bank, it’s about how much cash flow you can generate on a monthly basis that undermines your standard of living. Hey, just remember that the goal is to achieve financial independence.

Getting Rid of Debt

There are many methods that people will suggest to pay off debt. Debt is oppressive. For many people, paying debt is the last thing on their mind because it gets in the way of things that make us happy. There are suggestions that using the snowball method of paying debt is the most motivational tactic, but from a cash flow efficiency perspective, it falls short.

Let’s take a contrived example. I like to make things up because I personally hate debt and wouldn’t want to accumulate something like this:

debt_pay

All these types of debt use simple interest calculations. I didn’t want to include mortgage debt because quite frankly, that’s a different beast in itself.

So let’s consider you can pay the minimum payment for each loan, but you have an extra $100 that you can throw at one of the loans. What do you do?

If you find yourself in a bummer mood and hate paying off your debt, some financial advisors would suggest to tackle the smallest debt first and get that paid off. Once that is paid off, take the amount you were paying and throw it into the next smallest amount. It’s sort of a motivational tactic to get you excited that you’re accomplishing something.

debt_snowball

You look at that and think “Yessss!” I got my line of credit paid off in 5 months. Now that’s a financial accomplishment you can throw on Reddit and post on your Facebook wall. You’ll get a ton of congratulations. Maybe some high fives from some friends at work, but aside from that you might have actually made your cash flow situation worse. Why’s that?

Well you tackled the easiest thing first, but the interest rate on that debt was by far the lowest one available. That meant while you were busy paying off the line of credit, the credit card debt with a 19% interest rate started compounding like crazy.

The approach that is a bit more superior to paying off your lowest amount first, is to tackle the debt with the highest interest rate first.

debt_laddered

In this approach, nothing gets paid off. Oh yeah great… I’m telling you to not pay off anything now. How the heck is this even a better approach? OK before you start roasting me some more, let’s take a look at the numbers.

It’s true that the first approach lets you get rid of one of your debts faster, but if you look at the amount of interest paid in the first approach per month, it’s actually more than the second approach. Remember that interest is the extra cost that you have to pay for borrowing money. Why the heck do you want to pay more interest?

I’ve mentioned that cash flow is the most important aspect of financial independence. You want to start reducing the outflows in your monthly budget, which means it’s smarter to reduce the amount of money you owe and also the costs of holding debt at the same time. It doesn’t make much sense to pay off your loans, but at the same time incurring higher interest costs.

Now I’m not going to say that all financial advisors are stupid for recommending the first approach. As I’ve said many times over and over again, money is an emotional matter. The fact that a loan is paid off to some people is worth the extra dollars it takes to pay off the lowest amount first. You can’t put a price on happiness.

Stay Persistant, Avoid Pitfalls

Homer-Simpson-Mocks-Ned-Flanders-The-Devil.gifDebt can be a drag. I can’t even sugar coat it because I can’t think of a positive affect that it can have. It forces us to slave away at our jobs because we’re always in fear that someone is going to come after us to get their money. The only antidote is to have a strong will. Don’t let debt defeat you. Set the course and stick with it. Don’t let anything deter you from eliminating your debt. When you can finally get debt free, it’s probably the financial accomplishment of climbing Mount Everest. Seriously, how many people do you know that live debt free? Probably few.

The most important thing is to not fall into indulgences that you cannot afford. Learn to say no. Save for the luxuries. Taking debt is such an easy approach to achieving short term happiness. When the devil reaches out with rewards, make sure you turn and run.

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