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Money Guide – Debt



The following is adapted from “Living in the Village: Build Your Financial Future and Strengthen Your Community” by Ryan C. Mack.

– Pay Debt and Invest Simultaneously
– High-Risk Debt = Credit Cards, Payday Loans, IRS Debts, Cash Advances
– Low-Risk Debt = Mortgages, Car Loans, Student Loans


– The Two Types of Debt
– The Benefits of Paying Down Low-Risk Debt Early
– A Strategy to Eliminate Debt

Debt is like a slippery slope – you can slide down easily, but if you want to climb back to the top, it can feel impossible. There are two types of debt: high risk and low risk. Understanding their role in your financial success is imperative.

TWO TYPES OF DEBT


High Risk Debt
High-risk debt is any debt that has an interest rate that can go sky-high if you don’t pay it back. Examples are credit card debt (the most common type), cash advances, payday loans and monies owed to the IRS and collections. These debts and their high interest rates give consumers a headache and are the primary reason that most Americans operate their household at a deficit. It is hard to get ahead in your savings if all of your capital is going to fill the pockets of your credit card company through interest payments.

Low-Risk Debt
Low-risk debt,also known as secured debt, is called low risk because it is usually backed by an asset. As a result, the interest rate on secured debt is therefore not as volatile or as high as you would find with unsecured debt, such as a credit card. If you don’t pay off the loan, the lender can come after your house, your car, or your wages. For instance, when you take out a loan to purchase a car, the car backs the loan and acts as collateral; if you purchase a home with a mortgage, the home acts as collateral for the loan; and if you take out a student loan, this is usually a secured debt and the lender can stake a claim to your wages if you do not repay.

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DEBT VS INVESTING

A common question we get at The Money Movement when discussing paying down debt is “Should I pay off my credit card debt completely before I start investing in my emergency fund or saving in my 401(k)?” The answer to that is “It depends.” Mathematically, a major wealth-building principle is to make sure that interest is always working for you and not against you. If you are earning 2 percent in an emergency fund but paying 15 percent on credit card debt, it makes numerical sense to pay off that credit card debt first.

However, if you spend all our days paying down credit card debt and continue to see a big fat zero in your savings account, you may suffer what we like to call “fiscal fatigue.” Seeing growth in your savings account gives you motivation to keep going.

So, when determining whether to pay down debt or to invest in your emergency fund and 401(k), the answer is usually to do a little of each. After you have done your budget and determined that you have a $200 surplus (money left over after all expenses are paid), a 50/25/25 percent split could be appropriate. That means 50 percent ($100) of your funds going toward your credit card debt, 25 percent ($50) going toward your 401(k) (or possibly more if your company matches), and 25 percent ($50) going toward building your emergency fund in a high-yield savings account.

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Financial Benefits of Paying Off Debt Early


Although we suggest paying down high-risk debts and investing simultaneously, you may revisit this question when looking at low- risk debt. The table below shows the interest paid when making a $200-per-month payment and a $350-per-month payment. As you see, you can cut the amount of interest paid almost in half by paying the additional $150.

Debt Balance

Interest Rate

Monthly Payment

Total # of Payments

# of Years to Pay Debt

Total Interest Paid

$23,186

5%

$200

159

13.3

$8,550

$23,186

5%

$250

118

9.8

$6,183

$23,186

5%

$300

94

7.8

$4,855

$23,186

5%

$350

78

6.5

$4,002

Since low risk debt is less volatile, depending on your comfort level you may choose to invest that $150 in the market. Its all up to you and which options makes sense for your overall financial goals.

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DEBT ELIMINATION STRATGEY


One of the best ways to pay down your debt is the “snowball method.” This method uses all or the majority of your budget surplus to “attack” the smallest item of the debt owed. After you eliminate this debt, your surplus is increased by the minimum payment of the recently eliminated smallest debt, and you use your newly enhanced budget surplus to pay down the next smallest debt owed…and so on. This method essentially allows you to build momentum as you pay, gives you motivation to continue, and forces you to organize your debt efficiently. Here is how it works. Write out all of your debt on a sheet of paper from the largest amount owed to the smallest. Here’s a sample:

Company Owed

Phone Number

Mailing Address

Minimum Due

Balance Owed

Line of Credit

Interest Rate

Bank 1

XXXX

XXXX

$50

$4,200

$5,000

13%

Bank 2

XXXX

XXXX

$75

$2,500

$3,000

7%

Bank 3

XXXX

XXXX

$100

$1,400

$3,000

10%

Bank 4

XXXX

XXXX

$50

$500

$1,000

10%

Once you’ve organized your debt, make sure that you have a sound budget to calculate your monthly surplus (the amount of money you have left over after all of your expenses are paid). Your budget should include within it the minimum due monthly on each piece of debt.

Using the above example, let’s say that you have $200 left over after expenses as your monthly surplus. You take the $200 and apply it to the lowest amount owed. In this example you would pay down Bank 4 debt by an extra $200. After two months of paying an extra $200 month to your Bank 4 debt, you will have paid down the $500 and eliminated the Bank 4 debt. Now you have an extra $50 free, because the minimum due on the Bank 4 debt was $50, and your entire surplus increases by $50 to $250.

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Now you need to apply the $250 to Bank 3 debt. After four months of paying $250 plus the $100 minimum to Bank 3, that debt will be eliminated. Your surplus increases by $100 (the minimum to Bank 3), and you now have a total of $350, which can be applied to the debt owed to Bank 2. As you can see, the excess surplus snowballs until all debt is eliminated.

If you notice, Bank 1 has the highest interest rate, but is the last to be paid off completely. That’s okay – The Money Movement has found the progress that people see and feel by actually eliminating debt is worth more in motivation than the extra money being paid in interest. When you can physically see a bill eliminated, it gives you a sense of accomplishment. Now, if you feel that you would rather organize your snowball strategy and pay your debt down from the highest interest rate first, that is your call. Just be aware of that fiscal fatigue that can come into play when you are paying the same debt down for months and still have multiple bills to be paid off. Either way, just keep in mind that you are doing the best thing for your financial health.

Managing debt responsibly is very important. Your credit report gives lenders a clear view of your debt personality. What they see plays a major role in your ability to get the lowest interest rates. The interest rates you get in turn play a major role in how long it takes you to pay off your debt. How long it takes you to pay off your debt plays a major role in how quickly you achieve financial independence. It’s all connected capiche?

Didn’t find what you were looking for in Money Guide:Debt? Send us an email at info@moneymovement.org and one of our experts will get back to you.



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