Paying down debt

Emergency account funded, now what?

Now that you have your emergency account opened and funded to cover at least three months of expenses, it’s time to start the journey in becoming debt free!

It is certainly worthwhile to continue to contribute to your emergency fund until you reach six month’s expenses, but now we can start to focus on reducing and eliminating debt.

Types of debt

Bad debt

This includes things such as credit card balances (this includes your store credit cards) and auto loans.

Carrying a credit card balance and not paying off the entire amount each month generally results in high interest accumulation that typically compounds each month it remains only partially paid off. This can often snowball into a sizeable sum in a short period of time depending on spending habits. It is recommended that you pay off all credit card balances in full each and every month to avoid interest accumulation. The average credit card interest rate stands at 15.07% with a maximum allowable at 29.99%. Not even the stock market can guarantee returns like that every single year!

Auto loans are also considered bad debt because the value of the car immediately drops when you sign those papers, even before you actually drive the car off the dealership lot. The instant and continued depreciation of a vehicle coupled with a fixed loan amount and a repayment option makes an auto loan a bad debt to carry. You can always buy a solid, used car that will run for years for cheap.

Good debt

Good debt is something that gives back and generates value. This includes mortgages and student loans.

Buying a home and taking on a mortgage does not immediately cause the home to depreciate in value. In addition, it creates value in giving you a place to live with the potential of increasing in value. Mortgage interest paid can also be taken as a deduction if you itemize your taxes when it comes time to file. Good debt.

I’ll be completely honest and say even though student loans are considered good debt, I believe there has to be enough return on investment to consider it a good debt. Taking on 100k in student loans to graduate in a major that results in a career ceiling of 40k salary per year does not seem like taking on “good debt” to me. Student loans have to be reasonable for the associated career upon completion, otherwise it does not create enough value to incur that debt in the first place. Just like mortgage loan interest, student loan interest paid can also be taken as a deduction during tax season.

Start with the highest interest rates

interest rates can snowball debts out of control

Interest rates can snowball debts out of control

Always pay off at least the minimum amount each month towards each debt that you have, otherwise they will charge you with hefty fees that will only increase your debt burden (no point giving them any more money than you have to).

First, calculate the minimum monthly payment for each outstanding debt you have and add them up. This is your total monthly debt repayment. Add this amount to your regular monthly expenses and subtract that from your monthly income. Take whatever amount is remaining or left over and put that towards paying off the debt with the highest interest rate.

If you want, you can even put aside a little bit of what you have remaining towards getting that emergency fund up to 6 months expenses, and then put the rest into paying off that high interest debt.

Once the highest interest debt is completely paid off, take the monthly payment you were making for the first debt and apply it to your second highest interest loan until that one is paid off and continue on. This way, your payment toward reducing debt is the same each month, but you will be reducing your debt load so much faster by snowballing your debt reduction payments down the line from highest interest rate down.

Surprisingly, by paying down debt, you will more than like take your net worth from a negative to a positive amount, and you can certainly give yourself a pat on the back once all your bad debts are completely paid off. If you are interested in learning about net worth, you can take a look at my discussion about whether or not you should be tracking your net worth.

Time to start building wealth

Once your debts are paid off, try not to accumulate any more bad debt. By paying off these debts, it frees up money that can be used to build financial wealth and create stability in your life.

If you are curious, you can check out my investment strategy for 2015 and let me know what you think.

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