Give yourself a raise. Pay off your debt.
I want you to give yourself a raise. You deserve it. Your family deserves it. I want you to build wealth. Paying off bad debt is how you give yourself an immediate raise. Here’s my simple approach:
When you pay off a 20% interest rate credit card, you just made 20% more on that money.
When you pay off a 6% loan, you just gave yourself a 6% increase in purchasing power for that cash.
When you pay off your 3.25% mortgage, you just found a way to make that money work 3.25% harder.
Many clients ask me how they should go about paying off their debt. It is a common theme of my financial coaching business. Eliminating liabilities or debt is always an important part of building wealth or net worth over time. However, there is some debt that is considered good debt and paying it off at the sacrifice of building assets is not always recommended. Here is the step-by-step approach I take when clients want to discuss paying off debt.
Step 1: Make a debt portfolio. This sounds complicated, but it is not. It’s a simple list and hopefully it all fits on one page. List out all your creditors, the amount of the debt or balance due, the interest rate you are being charged and the minimum monthly payment. I recommend putting them in the order of highest interest rate at the top of the page, lowest on the bottom. Here’s an example:
Capital One Credit Card: $6,500-17.99%-$163
Bank of America Credit Card: $5,000-16.99%-$121
Nelnet Student Loan: $20,000-6%-$387
Volkswagen Car Loan: $12,000-4%-$460
Citi Mortgage: $240,000-3%-$1400
Step 2: Determine how much extra monthly income you can dedicate to your debt payoff plan after your minimum payments are paid. Do you have a monthly spending plan (budget)? If not, now is the time to make one. By not creating and adhering to your spending plan, you have created bad debt, I’m sorry to say. Take the time to determine your monthly income and expenses. Can you bring in extra income? Can you comb down expenses? Figure out the dollar amount you feel comfortable paying extra toward your debts. Here’s the kicker and the special sauce for success. You can only pay 100% of this dedicated money toward your debt payments if:
You have an emergency savings set up for 3–6 months of living expenses.
AND. . . . . .
2. You have set up and funded a short-term savings account to hold your annual expenses that tend to pop up and get put on the credit card. You need to hold money aside for car repairs, home repairs, vacations, gifts, and other items that creep up and get put on credit when not accounted for. This is the #1 tool for eliminating credit card debt.
Don’t have an emergency fund properly funded? Don’t have a short-term savings account with enough funds to cover those unexpected expenses that mysteriously appear? Well, OK. That’s fine. If that’s the case we’re going to fix this problem. Put 50% of the extra money you are setting aside to pay debt towards these savings goals. The remaining 50% gets used to pay your highest interest rate debt at the top of your debt portfolio list. Why? We’re ensuring you stop the bleeding and don’t have a need to add more debt to your credit cards.
Step 3: Start paying more than your minimum payment toward the debt at the top of your list. You may have heard information about the snowball vs. avalanche debt elimination methods. The snowball method suggests you pay the debt with the lowest balance or overall amount due first. The idea here is that you get rewarded faster for eliminating the number of creditors or debts on your list. This is strictly a psychological benefit. It does not make the most sense financially. See my example above. Do you want to pay yourself 20% or 6%? I thought so. I recommend the avalanche method, which tackles your highest interest rate first. This has more bang for your buck, but may not be as psychologically satisfying. I’m interested in you making more money for yourself immediately so you can start to pay yourself rather than paying banks or lending firms.
Congratulations. You now have a smart debt elimination plan. When you have your emergency fund and short-term savings account fully funded, move from 50% to 100% of your extra cash paying debt. When you have paid all debt with interest rates higher than 6%, you now have an opportunity to start investing in additional assets. This, of course, depends on your risk tolerance and other factors. That’s another topic. Stay tuned. But for now, give yourself a raise and pay off that bad debt.