After my last post about what an emergency fund is and how to build one up, I’m hoping that everyone who read it is on their way to get that started!
Having something as basic as an emergency fund is a must, especially in times of economic stress. I’m not going to get into a dissertation about the next few years, but let’s just say that for a number of systemic reasons, we are not going to get away from economic stress for quite some time. As a result, you need to start that emergency fund … yesterday!
Once that emergency fund is working it’s way up to a reasonable funding level, it is time to start killing any and all debts that you have. There are a million reasons why, I’m only going to talk about a few of them here, then I’ll give you two simple plans to kick the debt habit.
The rich rule the poor, and the borrower is servant to the lender – Proverbs 22:7
Think for a moment about the debt that you have and what it really means for financial health on a monthly basis. Let’s take as an example a common expense for many Americans, the monthly car payment. The loan that you took out to buy your car provides you with a car today, and obligates you to pay a lender a few hundred dollars every month until the debt is serviced in full. You don’t own the car, you are simply borrowing the car and are indebted (a servant to) the lender. Your work is their profit, every month until you can pay off the car. If you cannot make your payments, the lender will take the vehicle away and you will be without a car, and without anything (except a jacked up credit score) to show for your months of payments. Then course there is the issue of how much cash you end up spending to purchase the vehicle vs. the actual cost of the car, but that doesn’t matter all that much – what matters is that you are financially enslaved to another person/entity. In times of stress like this, maximum financial flexibility is critical.
An example…
Let’s assume that you take home $3,000 per month after taxes. If your mortgage is $1,200 and your car payment is $300 then fully 1/2 of your take home pay is spoken for each and every month. In order to simply cover your debts you need to take home $1,500 after taxes each month. If you could simply remove the $300 burden, that would reduce your minimum fixed costs by 20%. That would also provide you with an effective increase of 20% in spending/savings capability each month.
Is that car really worth $3,600 a year in lost spending/savings capability to you? Do you really need the latest and greatest whatever it is? Do you really want to be enslaved to the tune of $3,600 each year to a lender?
All of these questions are working to get at the heart of debt and what it means to you. Debt is like a financial noose around your neck. There is of course some debt that is good and can help to make you and others better off; however, that is another topic of discussion. When you borrow to consume you are effectively lighting a match to your cash, and your financial health. This of course gets worse and worse as we get further and further into debt…
Levering up, with more debt – the credit card!
Let’s take that quick example from above and make it a touch more dramatic (and sadly, realistic). Assume that you have the average household credit card debt of $8,000… We’ll use some basic figures like a 3% minimum payment, interest rate doesn’t matter for this discussion. The reality is that you are going to be spending and additional $240 a month just to service that debt! So now, you have another $2,880 in debt service obligations each year – a total of $6,480 or 18% of your take home pay in my simple little example. Imagine simply ridding yourself of the credit card and car payments and getting an effective raise of 42% in spending/savings power every year!
For the math geeks out there, that is ($36,000 – $14,400) / ($36,000 – $14,400 – $3,000 – $2,880) – 1 = 42% change in discretionary income.
This of course becomes much more dramatic if you include things like food and utilities as non-discretionary expenses. But lets just keep it simple for now. We don’t need to over complicate things
I’m sold, let’s get this paid off!
The rubber is about to meet the road here. First things first – make sure you have an emergency fund setup. I’m dead serious about this, get that emergency fund setup first. The last thing you need is to pay off $1,000 of debt only to have some random expense come up and totally destroy the emotional wins that you’ve just made. This will cost you a few extra dollars in the long run, but the emotional and momentum gains it will give you are critical. So get that fund setup!
What makes you tick…
Before we work through the two methods to pay off the debt, ask yourself a question… Are you predominantly guided by logic and rational decision making, or emotional decision making. Be honest, this choice may mean success or failure in paying off your debt. Using the simple rules below, pick a target debt and then follow the 7 step process…
Emotionally driven folks should target the debt with the smallest balance first, when that is paid off, move onto the next smallest balance – always.
Rationally/logically driven folks should pick the debt with the highest interest rate, when that is paid off, move to the next highest interest rate debt, always.
The difference in the two approaches is simple. For the emotional folks, you will build momentum by paying off a small debt first. That gives you the high you typically feed off of to continue the quest to kill your debt! For the rational folks, I don’t want to see you get hung up on paying off a small interest rate card first and then give up because you rationally (and correctly) think that you are paying down the wrong debt based upon the overall cost. The reality is that in the end, the differences between these two approaches is so small that it doesn’t really help or hurt either side to pick what works for their brain. Just pick what feels right.
7 Steps to get out of debt
- Carve out some cash to extinguish debt.
- This could be the money you were saving to build your emergency fund, or better yet – this could be the cash you save from scaling back your cell phone plan, cable plan, eating out habits or any other part of your life. You don’t have to be a hermit, but you need to spend within your means, so identify the fat and kill it.
- Pay all minimum payments on your accounts – all of them.
- On the account identified as your target account, add your savings identified in step one to the payment on that account.
- Repeat 2 and 3 until that first debt is paid off.
- Take all of the money that was being used to pay off your first target debt (minimum payment and extra payment cash) and apply that amount as the extra payment to the next debt you’ve identified as a target.
- Repeat steps 2 and 3 until that is one is gone
- Repeat steps 5 and 6 until they are all gone!
Using this simple little plan against the debts we discussed in the example above will pay these off in a relatively short order of time and save you $6,480 a year in payments! That is a huge increase in saving/spending capability going forward. I’d suggest that you save at least 1/2 of that money, preferably more, but that is up to you!
Enjoy your new debt free life – it’s fun to have a lot more money without getting a raise from your employer. You’ll feel better about your financial health, your stress will go down and heck, you can now take a vacation and pay cash as a reward if you want to. Just remember, debt enslaves you, so save up first, then enjoy the fruits of your labor!
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