Budget Bootcamp Week Five: Dealing with Debt

Debt is something not many people like to talk about. Let's face it, debt can be overwhelming, scary, and daunting. However, getting out of debt is something that tops the list in terms of goals for most people. And once you're out, the trick is staying out. According to USA Today, the average American household carries over $16,000 in credit card debt alone. This figure seems alarmingly high considering it doesn't account for anything other than credit cards! First of all, not all debt is created equal. There are different categories of debt to consider. I like to refer to them as good debt, bad debt, and depends debt. Today we're going to cover each of these categories, as well as some strategies for digging ourselves out.

Source: Pinterest

Types of Debt: 
Good debt would refer to purchases viewed as an investment for the long term with an expected return on investment (or ROI). Examples of good debt could include things like a mortgage, business loan or an investment property. These are all endeavors that most people need to finance, as we usually don't have an extra $60,000 or more dollars just lying around. These types of loans generally come with a relatively low interest rate and have a life span of 15-30 years.

Examples of bad debt include things that we often want, but don't have the cash for right away, so we charge them to our credit cards. This is where most people get into trouble. Instead of saving up for that new TV, remodel, or vacation they really want, they put them on their credit card and it adds to the balance they carry from month to month. Most credit card companies charge 11-24% interest depending on varying factors such as credit score, payment history, and the size of your balance. That $600 TV is actually costing you $666 or more if you don't pay off your entire credit card balance at the end of the month. If you carry that balance, every month it keeps costing you more and more. This can become a slippery slope that takes a long time to dig out of.

The "depends" debt is just that - it truly depends. Here I'm referring to things like student loans or auto loans. The reason they depend is because there are lots of variables here. These are loans that sometimes are necessary, but need to well analyzed. Are you taking out a massive student loan for a degree in a field that's highly competitive, low paying or hard to find employment in? This type of risk could leave you with student debt lingering for the next twenty years of your life and cost you over double what it was actually valued at. Or are you taking out a reasonably sized student loan that can advance your career with low risk? One you'll be able to pay back in just a few short years, or even better, before your program is even completed? This type of student loan is smart because its both manageable and sets you up for better financial security down the road. In the instance of auto loans, are you needing safe and reliable transportation for you and your family? Is this vehicle necessary for you to get to and from work, thus needed to pay your bills and uphold your responsibilities? Then this purchase would be deemed necessary and worth financing for. If you just are wanting the newest features, "coolest" truck or a flashy sports car but your current mode of transportation is perfectly suitable, then taking out a loan isn't a wise choice. If you have enough value to trade in for this type of upgrade, then by all means go for it. This type of a purchase is something you should hold off on until you can pay for it outright. Otherwise, stick to something a little more practical and stay within your means. Remember, vehicles depreciate in value very quickly, so they aren't something you can expect to get much out of down the road should you change your mind.

So now what?
If you have zero debt, congratulations! That's quite the feat and I'm certain it has taken some serious diligence to get there. If you have minimal debt and debt that is either good or easily manageable, you have probably had to make a good deal of sacrifices to get there. If you feel like you are drowning in debt coming from all different angles, do not give up. Every step you take to eliminate debt you will feel so much better about. No two lives or families are the same. Every situation is different and how you got to where you are isn't nearly as important as how you're going to move forward.

When it comes to paying off debt, the first step is knowing exactly how much debt you have, who it's to, when it's due, and what your minimum required payment is. I've created a printable here that you can use to keep all this information tidy and in one place. These debts need to be accounted for in your monthly budget. Things like mortgages, auto loans and student loans are things we already discussed creating a category for on our budget worksheets. If you have any other forms of debt, please add a line to account for those too. If credit card debt is what you're up against label it that and indicate the total minimum monthly payments required for all your combined cards.

Source: Pinterest

Now that you've accounted for all your potential debts, let's start chipping away at them. This is where you'll have to do a little work to find out what makes the best sense for your situation. There are a few different ways to approach debt payoff. The first is the Snowball Method made famous by Dave Ramsey. He talks about tackling your smallest debt first ($500 in credit card debt for example), then moving to the next smallest ($750 on another credit card we will pretend), then to the next ($8000 on your vehicle) then the next (maybe $20,000 on your student loans) then the largest for last (maybe $80,000 on your mortgage). The concept here is to gain momentum as you go, much like a snowball does as it rolls down a hill. The idea is to gain confidence and celebrate the milestones as you knock them off, which will fuel your fire to keep going. Keep in mind, that while you focus on that first $500 debt, you can't entirely ignore the others. You continue making all your required minimum payments to each of them, you avoid adding any more debt, and you push as much extra money to that debt you're focusing on as possible. In order to eliminate debt, you have to go above and beyond. So paying double, triple or even more (as much as possible without neglecting other needs) on that debt of focus will get you out as quickly as possible. Once your first debt is knocked out, you start applying all the money you'd been paying towards it each month toward your next debt. You're following me, right? This strategy is great for those that have numerous debts and need a starting place pronto. If this seems like the right route for you, I highly encourage checking out Pinterest for some ideas of how to get started. I've seen lots of creative trackers and charts that others have used to keep them going.

But what if you only have a few debts, that are significantly larger? That's where Jason and I are. Our debts include our mortgage and our van. We have big goals to pay off our 30 year mortgage in less than 20 years. And we are on track to do it. Our van payment is scheduled for 48 months, and obviously is much less costly than our home. So why wouldn't we pay off the van as fast as possible, and then worry about the mortgage? Two words: Interest and Leverage. If we paid only the exact amount owed each month for the next 30 years, we would pay for the purchase price of our home, plus an additional 71% just in interest. I'm not getting 71% more house at the end of it all, so why would I want to pay anymore than absolutely necessary for it!?!?! So in the interest (yes, pun intended) of saving significant amounts of money in the long run, we've chosen to pay this debt down as quickly as possible. That's not to say I want to pay loads of interest on the van, because I don't. But remember how I mentioned leverage? Here's what I am talking about. Let's say we deemed that we were going to pay an extra $500 a month towards our debts. We could throw that $500 at the van balance, at the mortgage, or split it 50/50 to each. It's still $500, right, no matter how you slice it? Wrong. It might be $500 spent, but how much is it saved?

If I threw all $500 in additional payments each month toward the van, I would have it paid off 13 months early and save $677 over the next 3 years. If I split it up, an additional $250 to the van and $250 to the mortgage would save me a total of 8 years, 11 months and $15,530 (8 years on the mortgage accounting for $15,180 and 11 months on the van accounting for $350). Not too shabby, right?  But if I put that $500 towards the mortgage, it would have us done with our 30 year mortgage in only 17 years, saving us over $37,000. Crazy, right? So I'll gladly pay the bank an extra $677 in interest for the van to save $37,000 in interest on the house.

I know that was a lot of math thrown at you. But I wanted you to see the power of paying off debt and that HOW you do it can make a huge difference. To find out how much money you can save, I use a debt payoff calculator like this one. Interest and late fees are two of the biggest ways Americans waste money with nothing to show for it each year. Yes, some of it is unavoidable, however, lots of it is unnecessary. Take some time this week to assess your debts, play with some hypothetical situations, and determine what course of action you'll take to resolve them. Once again, I am in no way a professional financial advisor or expert on debt and money management. These are simply techniques and methods I have used in my own life to gain financial security. My goal is that by sharing these experiences with you, you'll be able to do the same.