How to Get Out of Debt
At Millennial Economics we believe that getting out of debt is an instrumental part of achieving your financial goals. In this article, we will discuss how to get out of debt, but first, we need to understand how debt affects our wealth building.
How Does Debt Affect Building Wealth?
There is great debate in the finance community around the topic of debt. Some people believe all debt is bad while others believe debt is a tool used to build wealth. I will attempt to keep this article as unbiased as possible. My goal is to present the facts to you plainly and leave it up to you as to what types of debt if any, you are comfortable having.
To start, there is inherent risk with any type of debt. No matter if it comes with a low interest, is in the form of a mortgage for your home, or a loan from your parents. Debt is a “promise to pay”, but what happens if something happens in your life that stops your ability to make the repayment? This is the risk that comes with all types of debt.
Maybe you have a salary of $100,000 and you’ve been making that amount of money for several years, it would seem like a fairly low-risk decision to take a mortgage out on a house in this scenario right? Well yes, but what happens if you lose your job? What happens if you get sick and can’t work for a period of time?
I don’t say these things to make you afraid of debt, but I instead say it to remind us that there is risk involved with any type of debt. That is important for us to remember.
Is All Debt Bad?
I would personally say no. The assumption I’ve come to based on my experience and knowledge is that debt in the form of a mortgage is not terrible. It’s debt for an often appreciating asset that also provides us a place to live. Some would also go as far as to say that debt for any asset is good debt. I would tend to disagree, but deciding which debt is right or wrong for you is your decision. Many people have built large amounts of wealth by being highly leveraged, but it is also worth noting that many people have driven themselves to financial ruin leveraging other people’s money as well.
What is Leverage?
Leveraging money means using someone else's money to purchase something, preferably an asset, that’s going to make you money in the future. A good example of this is taking a loan out from a bank to buy an investment property. You’re taking that money from the bank in order to buy a home you can’t afford on your own with the hope of that property making you money in the future.
Many people have become very wealthy leveraging other people’s money, but many people have also driven themselves to financial ruin because there is risk involved with all types of debt. Leveraging other people’s money can be a quicker way to build wealth, but it might not be a great option for you if you’re risk-averse. I find myself being fairly risk-averse, and my plan is to avoid leveraging large amounts of money on risky investments. I don’t plan on borrowing large amounts to start a business or to buy millions of dollars of real estate. You can even leverage other people’s money to buy stocks! While I don't think all of these leveraging scenarios are terrible ideas, I assess each scenario uniquely in my own life and make my decisions that way. I would encourage you to do the same.
Is Credit Card Debt Bad?
High-interest credit card debt is always bad. According to wallethub.com, the average credit card interest rate is 17.98%.
Let’s take a look at a credit card minimum payment calculator.
In our example, if you make a $1000 purchase on a card that charges 17% interest and you only make minimum payments on that account you will end up paying $1,170.99 in interest alone over 11.4 years. Does that $1000 purchase seem worth it?
High-interest credit card debt will kill your financial progress. If you have it, get rid of it! If you don’t have any now, never explore it as an option! If you find yourself with high-interest debt, paying it off is a guaranteed rate of return reflecting whatever your interest rate is. This debunks the theory that you should invest while having high-interest debt. Paying off that debt is the best return you're going to get, and it’s guaranteed!
Is Having Debt on a Vehicle Bad?
Similar to high-interest credit cards, debt on your personal vehicles will greatly inhibit your ability to build wealth.
The average car payment in the US is $554, and the average auto loan interest rate on a new car is 5.61% and 9.65% for used cars. This may not seem like such a bad number after analyzing high-interest credit cards, but when it comes to vehicles we also have to take into account depreciation.
A new vehicle on average depreciates 19% in the first year. That same vehicle typically depreciates 15% in the second and third years. So not only are you paying interest on that auto loan, but your purchase is doing the opposite of what we want to happen with our money. We want our money to grow, not get smaller. Financing vehicles is a sure way to stunt your financial growth!
So we’ve learned that there is risk involved with any type of debt. Keeping a balance on high-interest credit cards and financing vehicles is a sure way to stunt your financial growth. We have also learned what leveraging money is and the risk associated with it. At the end of the day, you will have to analyze what types of debt you’re comfortable with and what types of debt you’re not. Do your research and remember that building wealth isn't a sprint, it's a marathon. Analyze your risk tolerance and make well thought out decisions, and you’ll be on your way to achieving your financial goals.
How to Get Out of Debt
Now that we understand the effect debt can have on our finances, let’s talk about how to get out of debt.
There are two main methods the majority of the finance community suggests when discussing how to get out of debt. We will discuss them both.
The Debt Avalanche Method
In simple terms, the Debt Avalanche method involves listing your debts from the highest interest rate to the lowest and paying those debts off starting from the highest interest debt to the lowest interest debt.
Let’s take a look at an example.
We will take a look at Susie. Susie is 30 years old. She has $14,000 in student loan debt at 5.8%. She has a loan on a Honda Accord for $22,000 at 9.65%. She also has a few credit cards she has been using for years with balances of $8,000 at a 17% interest rate and $10,000 at a 20% interest rate.
If she were to subscribe to the debt avalanche approach she would list her debts as follows:
Credit Card - $10,000 at 20%
Credit Card - $8,000 at 17%
Honda Accord - $22,000 at 9.65%
Student Loan - $14,000 at 5.8%
She would then proceed to pay off her debt starting with the highest interest account first followed by the second-highest and so on.
This is the debt avalanche approach to paying off debt. This approach makes the most financial sense. By paying the highest interest balances first she is saving herself the most money possible in her debt-free journey. Many people subscribe to this method and it has worked for many.
Now let’s take a look at another method.
The Debt Snowball Method
In contrast to the debt avalanche method, the debt snowball method does not take into consideration the interest rate on a given balance.
Let’s use Susie as an example again.
If Susie were to use the debt snowball method she would list her debts from smallest to largest and begin paying off the smallest balance first and work her way to her largest. Her order of debt payoff would look something like this:
Credit Card - $8,000 at 17%
Credit Card - $10,000 at 20%
Student Loan - $14,000 at 5.8%
Honda Accord - $22,000 at 9.65%
People who favor the debt avalanche method argue is the method that makes the most mathematical sense, and they would be correct. Paying off your highest interest debts first saves you money in the long run because you will not be paying the higher interest on your balances as you pay them off.
People who favor the debt snowball method take into account the emotional and behavioral aspects of paying off debt. They start with the smallest balance first and try to pay it off as quickly as possible. This smaller balance allows them to experience a quick win which motivates them to keep diligent with the paying off of their debt.
I personally favor the debt snowball over the debt avalanche method. I believe the psychological and emotional side of finance isn’t discussed or taken into account nearly enough with personal finance. I believe that if money management was purely a numbers game we would see far more people winning with their money. The reality is, personal finance is just as much an emotional and psychological exercise as it is a numbers exercise. We are humans and because of that we often let our emotions and thoughts dictate our actions. It would be wise to take that into account.
In Summary
We have learned how debt can affect our wealth building, and we learned two different methodologies of paying off debt. Thank you for reading. I hope this article helps equip you with the knowledge you need to be successful. If you implement what you have learned you will be well on your way to financial success.
Continued Reading
How to Become Financially Successful in 2021
How to Start Investing in 2021 for Beginners
How to Get Out of Debt in 2021
***This article was not written by a licensed professional and the information is for entertainment purposes only.***