April is Financial Literacy Month in the United States. So far in April, I’ve talked about why money matters, why financial literacy is important, why personal finance is personal, and the #1 financial mindset for building wealth: tracking your income and expenses. In today’s post, I’m going to be sharing with you how to become debt free using the debt avalanche and snowball methods.
Look, being in debt restricts your ability to be free. Being debt free allows you to do what you want – without being tied to the expectations of a bank or another individual.
Many people ask, “How can I become debt free? What are the steps to becoming debt free?”
In this post, I will be answering those questions, talking about what debt actually is, and providing you two great strategies for eliminating your debt.
Let’s destroy that debt!
What is Debt?
First, what is debt?
Debt is money that you owe someone else. That someone could be a bank, another business, or a friend or individual.
For repayment, there are terms and conditions associated with a certain debt.
For example, banks lend individuals hundreds of thousands of dollars for a house and allow those individuals to pay back the money over 360 months (30 years).
In addition, there is an interest rate associated with your debt. This interest is the “cost of the loan” to you – no one is going to give you money for free!
Each month, you will have a payment and this payment will be part principal pay down, and part interest.
A Debt Payment Example
Let’s say you have a $20,000 loan with a 6% interest rate and a 10 year term. Using an online calculator, your monthly payment will be $222.04. Over 10 years (120 months), this will cost you $6,867.01 in interest. If you pay $100 extra a month, you can cut the time you are paying off your debt to 6.25 years (75 months) and you will pay $4,008.09 in interest. By paying an extra $100 a month, you will save yourself $2,858.92 and will be debt-free 3.75 years ahead of schedule!
As shown above, by paying extra each month, you can save money and reduce the amount of time you are paying off your debt. In addition, once the debt is gone you effectively give yourself a raise; you have more money falling to the bottom line each month for you to save, invest, donate, spend, etc.
Another thing to note: debt is legally binding. If you don’t pay back your debt, there are many negative consequences that can happen:
- Your credit score will tank and it will be more difficult to have a high credit score. Creditors report your delinquencies to the credit bureaus which are responsible for determining your credit score.
- You could be sued. Creditors gave you money for you to use and then pay back over time. If successful, the creditor and court can have your paychecks garnished until the debt is repaid – which means you take home less money each month.
- You might have to declare bankruptcy. Even though you will be able to get out of your debt, your credit will be ruined and your ability to get new credit will be destroyed.
Being responsible with your debt is very important because there are actually some benefits of being in debt.
Is all debt bad? Is there such a thing as good debt?
In general, I believe debt is bad – and many other personal finance bloggers and experts believe debt is bad as well.
That being said, I do think there are cases in which debt can be a good thing. (Remember, personal finance is personal – some people hate debt and believe all debts are bad,)
There are two conditions to meet for my classification of “good debt”:
- First, look at the underlying asset you are buying or receiving.
- If this underlying asset has the potential to appreciate, or increase in value, in the future, then it’s acceptable.
- Some assets I’m referring to in this case would be a house (houses have potential to appreciate over time, and provide you shelter), education (you have to be careful here, but with more education can result in higher pay), or a business (a start-up loan).
- Second, look at the interest rate.
- There is an opportunity cost calculation to do.
- Follow the financial theory: if your after-tax return on investments is greater than your after-tax cost of debt, then it’s acceptable to keep your debt.
- See related: my 2017 financial plan to pay down debt and invest.
Everything else is bad debt.
Credit card payments with an interest rate of 20%? Bad debt.
A home loan at 4%? Potentially good debt.
A student loan at 8%? I’m going to go with bad debt.
A car loan at 2%? This one is tricky – cars are depreciating assets, but the interest rate is so low it’s probably fine.
Again, personal finance is personal and depends on your goals. If wealth is your goal, it’s okay to carry some debt. If freedom is your goal, crushing your debt should be your #1 priority.
Strive to be Debt Free and Free Yourself
The word mortgage is derived from a “Law French” term used by English lawyers in the Middle Ages meaning “death pledge“, and refers to the pledge ending when either the obligation is fulfilled or the property is taken through foreclosure.
Literally, mortgage = death pledge.
“A man in debt is so far a slave.” – Ralph Waldo Emerson
Debt is horrible: it is mentally draining, financially draining, and affects your entire life if you are weighed down by the large barbell of debt.
I want you to experience amazing freedom. Make getting out of debt a goal, and I’m certain you will feel like a weight has been lifted off of your shoulders.
Think about it: with no debt, you wouldn’t be a slave to the bank, or to anyone. You’d have more money at the end of the month, and with more money, you’d have more options.
Unfortunately, today, I had to wake up and go to work because without my income, I couldn’t pay my mortgage. Until I sell my house, or pay off my mortgage, I have to continue working.
Two Strategies to Become Debt Free
There are two main strategies to become debt free fast. The two methods for becoming debt free are the debt avalanche method, and debt snowball method. To illustrate using these methods to pay down debt, I’ll be using my Debt Destruction Tool.
These methods are pretty straightforward. First, compile a list of your debts and their interest rates. After compiling this list, you will then pay a little extra towards a certain debt as determined by whichever method you pick.
By paying a little extra each month, you will be able to take advantage of some huge interest savings (as we will see a little bit later in this post).
The Debt Avalanche Method
In the Debt Avalanche Method, you pay off your debts by paying extra towards your debt with the highest interest rate. Once you have paid off the highest interest rate debt, you put the entire paid off debt’s payment plus the same extra amount towards the next highest until all debt is paid off.
For example, let’s say you have two debts: one at 20% interest rate, with a minimum payment of $200, and balance of $2,000, and the other debt with a 10% interest rate, a minimum payment of $150, and balance of $1,000. You decide you can put an extra $50 towards your debt a month.
Using the Debt Avalanche Method, you would put $250 towards the first debt and $150 to the second debt.
Over time, the first debt will be paid off faster than it would if you just paid the minimums. If the first debt is paid off before the second, then you put all $250 towards the second debt, for a total of $400 a month, until the second debt is paid off.
The Debt Avalanche Method is the mathematically optimal debt pay down strategy.
The Debt Snowball Method
In the Debt Snowball Method, you pay off your debts by paying extra towards your smallest balance debt. Once you have paid off the smallest balance debt, you put that payment towards the next smallest until all debt is paid off.
Many people like the Debt Snowball Method because psychologically, you can see your debt accounts disappear. If you have an $1,000 loan and a $5,000 loan, it feels good to have the $1,000 loan gone.
Let’s go back to our example with two debts: one at 20% interest rate, with a minimum payment of $200, and balance of $2,000, and the other debt with a 10% interest rate, a minimum payment of $150, and balance of $1,000. Again, you will put an extra $50 towards your debt a month.
Using the Debt Snowball Method, you would put $200 towards the first debt and $200 to the second debt, because the second debt is smaller in balance.
The Debt Snowball Method is not mathematically optimal, but is still better than applying no strategy at all.
Your Savings by Paying Extra Each Month
Let’s get out the debt destruction tool (if you don’t have it, it’s a free download that you get if you sign up for my newsletter).
I created an example where the user had 2 credit cards, a mortgage, an auto loan, and a student loan totaling $246,500.
By paying an extra $25 a month and applying a debt pay down method, in this example, there is potential savings of at least $49,915!
How is this savings achieved?
Looking at the left hand side of the figure below, you can see in the Avalanche method, we are paying off the highest interest rate debts first. Looking at the right hand side of the figure below, you can see in the Snowball method, we are paying off the smallest balance debts first.
By paying just a little bit more, debt can be eliminated quick, and our user became debt free with some solid cash savings.
I’ve also included some statistics if you increase your extra debt payments by $100. The difference is fairly substantial just by paying an extra $100 a month!
In our example, the user started out with $246,500 in total debt. If no method was used, it would take 290 months (just over 24 years) and cost $371,109 to become debt free. By paying an $25 extra a month, the user is able to save nearly $50k, and chop off 140 months (nearly 12 years) off their payment plan! If the user could find an extra $100 in their budget, they could save an additional $12,000 and be debt free 158 months sooner!
With either choice of debt destruction method, you will save money, and be on your way to financial freedom!
Destroy that Debt! Become Debt Free
While the tone of this post was mostly to eliminate your debt, there are times where having debt makes sense.
Remember, personal finance is personal, and if it makes sense for you to take on debt for a certain period of time, then as long as it fits into your future goals and plans, then do it! Right now, I have $12,000+ sitting at 0% for 3 years for some windows I got back in November. While yes, it’s a $12,000 expense, since it is 0% interest, I don’t pay an extra dime on interest, and when I pay it off in full in 28 months, I’ll be quite happy.
I ran the numbers and it made sense to me. Those windows have made this Winter in Minnesota much nicer, and they have also increased my home value.
Later on in this financial literacy series, I will be touching on my personal finance journey, and discuss some of these decisions more in depth – so you won’t want to miss out those coming posts.
Debt is something that can be used wisely and something you should be very careful with. You now have a great resource for answering the questions: what is debt, is there a difference between good debt and bad debt, and how you can become debt free using the debt avalanche and debt snowball methods.
If you haven’t picked up a copy of my Debt Destruction Tool, please make sure to subscribe below!
Readers: what is your opinion on debt? Are there good and bad debts, or is all debt bad? What debt elimination method do you like better?
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