10 Common Questions about Debt

The average US household debt is over $135,000 according to a recent study by Nerdwallet, in the UK it is just under £60,000. Those are huge amounts yet most of us see having debt as a “normal” part of life and might not even think twice about the implications of all these loans.

In this second article in the “10 Common Questions…” series we’ll have a closer look at debt, the advantage of becoming debt-free, different ways to pay off your debt and how to stay out of debt long term.

1: Why is paying off debt so important? 

Becoming debt free has many different advantages. One of the main ones being that it will save you a LOT of money. Debts are hugely expensive, much more so than most people realize. By becoming debt-free you are no longer wasting money on a loan for something you might have purchased months or indeed years ago. 

Another key reason to become debt free is to no longer be indebted to anybody else and take complete control over your money. Whether you have a loan from your bank, a store or the government, when you’re debt free, nobody but you can make a claim on your money.

If you do ever need to take out a loan, such as for a big purchase like a house, you’re also much more likely to get a loan and with better conditions. The more responsible you show you can be with money (i.e. not have lots of outstanding debts), the more likely you will be able to pay back your mortgage, the less of a risk you are to a bank, meaning they are more likely to grant you the mortgage and at a lower interest rate. 

2: But doesn’t everybody have debt? Is’t that just part of life?

Having debt has certainly become the default for most people and indeed for society as a whole. We see having debt as a standard thing in life, but that of course doesn’t mean that it’s actually the BEST option to pursue. Having debt costs money, ties you to your creditors and might keep you in a job you don’t enjoy simply because you need to pay all those creditors. 

Added to that, if you are looking to progress and get ahead or indeed pursue Financial Independence, you don’t want to do “what everybody else is doing”. If you want to achieve different results, you need to do different things to what other people do. How many people do you know who have debt? And how many of those are Financially Independent? I think that says enough. 

3: But my interest rate is only 1.5%. Surely that’s not so bad? 

A trick that many credit providers use is to state their interest in monthly percentages, when really you should be looking at the yearly percentage. A 1.5% interest rate means the annual interest rate is 18%. That sounds a lot more serious, doesn’t it? 

Let’s look at a quick example of what 18% means in terms of the total costs for you. 

If you had a $1,000 credit card loan at a 1.5% monthly rate and an agreed payment plan of 3% per month (meaning each month you pay back 3% of the outstanding balance you owe) and a minimum of $10, you would pay back the incredible amount of $1,779 in total on this loan! Not only that, in addition to the nearly $800 in interest you pay, it would also take you 9 years and 10 months to pay off this loan. That’s a huge amount of time for a loan of $1,000 at “just” 1.5%. 

4: But what about that new car / planned holiday / latest gadget I want?

Living with debt and therefore buying something before paying for it, has almost become a standard way of life: something many of us don’t even think about anymore and take for granted. But it doesn’t need to be like this. A much healthier, cheaper and satisfying way to purchase something new is by being able to pay for it up front instead of by financing it.

In order to do this, you’ll need to set up savings goals and plan ahead about when you might need to make a bigger purchase, such as that new phone, your holiday or replace your car. Once you’ve got a goal you can work backwards and decide on a set amount you need to put aside each month in order to be able to have the money saved up at the time you expect you might need the money to make the purchase.

Becoming debt free doesn’t mean you can’t get that new gadget, it just means you save up the money first before you purchase it and just requires a little bit of planning (and patience!). 

5: How long will it take to pay off my debt?

Of course this depends completely on how much debt you have and how much you are able to free up to pay towards this debt each month. There are many excellent online debt calculators available that can quickly show you just how long exactly it will take you to pay off each one of your debts. Let’s have a quick look at an example to show you how fast it might go though. 

Let’s use the same loan from earlier as an example ($1,000 loan, 18% interest rate, 3% monthly payback with a minimum of $10). If you were able to pay an extra $25 each month in addition to what you get charged by default by your credit card company, you would “only” pay $221 in interest, over $550 less than the original $779! Added to that, with the extra $25 a month you pay, it would take you just 31 months to pay off the loan (a little over 2.5 years) instead of the 118 months mentioned earlier!

As each loan and situation is so different, I recommend you use an online calculator to play around with some different numbers of how much you might be able to pay off extra each month and see what the effects of this are on the total costs of your loans. If you have more than one debt it’s important to choose the right strategy for you when it comes to paying off your loans: using either the snowball or the avalanche technique.

6: What’s this “snowball” technique?

The snowball debt repayment technique recognizes that paying off debt isn’t just a numbers game where all you do is consistently paying some money towards your debt. There is a substantial psychological component involved in this process too, more specifically: motivation.

Your motivation to get started on paying off your debt, your motivation to keep going even when the journey becomes dull or hard and the motivation to stick with the adjustments you need to make to your spending habits. 

The snowball technique encourages you to start with the smallest debt that you have, and begin to pay down this debt as fast as you can. In the mean time you keep making the minimum contributions to any other debts you have, you don’t want to accumulate more interest or penalties than needed after all.

By beginning with the smallest debt you will pay this off relatively fast, giving you a quick motivation boost as you witness the results. Then you move on to the next smallest debt for which you now pay off the minimum amount you were already paying + the money freed up from the first debt. Each time you pay off a debt, you free up more money to start paying off your next debt.

7: What about the “avalanche” technique?

The avalanche technique is similar to the snowball debt payment technique with one difference: instead of starting with your smallest debt, you begin paying off the debt with the highest interest rate. This is after all the one that, when left over time, accrues the highest amount of interest on it, meaning that by paying this one off first you save yourself a lot of money over time.

Like in the snowball technique, make sure to continue to make the minimum contributions to any other debts you have whilst you pay off your highest interest one, to avoid extra charges.

8: How can I stay out of debt?

There are three key things you can do to avoid going into debt again. The first one is to ask yourself whether you really need what you’re buying right now at this price. Is there a cheaper option available that would do? Can your old phone last another 6 months? Can you wait for a newer version to come out and buy the discounted older version? 

The second habit to develop is to set up savings goals and plans: if you know you’ll need a new phone in the next few months, then start saving up for this today by consistently setting aside money until you have the money available. 

Thirdly, accept that sometimes life throws a curve ball at us that can lead to instant costs you just have to pay in the moment: a broken washing machine, a car maintenance or a vet bill that you just need to get done in the moment. For these emergency situations, make sure you have an emergency fund available: start building up $1,000 set aside that you only use for these emergencies. 

9: Paying off debt… then what?

Once you get rid of all debt, and have put in place measures to avoid going into debt again in the future, that’s a huge achievement in itself and most definitely is something to be proud of. But it is only one of the pillars on your road to Financial Independence. There are other steps you can take, in the area of your income, investing, retirement that you can now focus on towards a secure financial future.

Commit to moving on to the next area of your finances and continue your journey towards Financial Independence. (One way to do this is of course to make sure you follow this series of articles!).

10: Where do I start?

The road to becoming debt-free isn’t easy but certainly worth it, so if you are committed to paying off all your loans, here’s what you can do:

  1. Find out all you can about your current debts: outstanding amounts, yearly interest rates and monthly payback amounts.
  2. Start by paying off extra money towards 1 debt using the debt snowball or avalanche technique. Free up extra money from a yard sale, a side hustle or by picking up extra hours at work. 
  3. Make sure to stick to your minimum payments on all other loans, don’t default on those monthly payments.
  4. Once you’ve paid off one debt, use all the money you’ve freed up from no longer needing to pay off that debt to start on your next loan. Keep at it until you’ve paid off your last debt.
  5. Start building up an emergency fund to avoid having to go in debt in the future.

This article is part of the “10 Common Question series”, where I address issues about some key financial areas, including Financial Independence, paying off debt, increasing your income, retirement provisions, saving, investing, financial protection and much more. If you want to find out more about Financial Independence, you can sign up to my newsletter to stay up to date or get a free sample of my book 100 Steps to Financial Independence. 

Photo by Republica from Pixabay

Part 4: Tackle Your Debts

Get your FREE sample of the 100 Steps to Financial Independence Book here

In part 4 of the 10 Parts to Financial Independence we’ll be looking at what for many people can be their biggest financial worry: debts. Whether you’ve got thousands of dollars in outstanding loans, or just a small amount, the most important thing you can do is to take action now. This post looks at how to deal with your current debts and avoid building up any more.

Part 4: Tackle Your Debts

The first step in becoming debt free is to understand how expensive it is to have debts. When you take out a loan, be that on a credit card, a mortgage, student loan or car loan, you pay interest on the amount you’ve been lent. Over time, this interest quickly starts to accumulate as your interest is calculated over your outstanding amount as well as over any previous interest that was added.

This compounding interest means that a loan of $10,000 at a 14% interest rate and a monthly payment of $188 will have cost you $5,707 in interest after the 7 years it takes you to pay off the loan!

There are many free interest calculators available on line, so as a first task go and find one that seems easy to use and of all your debts calculate how much they are truly costing you in interest over time.

The next thing to do now that you have a better idea of how expensive debts are, is to avoid taking on any more debt. Make a mental note -or even better: a physical one and stick it on your fridge or in your agenda- to not buy anything on credit anymore, unless it is an asset that you believe will appreciate (increase in value) over time. A second tool to help you stop accumulating more debt is to make sure to finish building up the emergency fund you started in part 3. That should help you not having to go into debt for any important but unexpected expenses that come up. 

Once you’ve built up that emergency fund, use any money that you have lying around, from a yard sale you might be able to organise, or from your limit-one-expense challenge to start paying off ONE of your debts. Choose the debt with either the biggest yearly interest rate or the one that is smallest in total outstanding amount (whatever you think would make you feel more motivated) and start making extra contributions to this debt. Even if they are small amounts, you’d be surprised how much of a difference this can make over time!

On a debt of $1,000 at a yearly interest rate of 18% and a 3% monthly payment plan, paying just $25 extra a month on top of the 3%, means you pay off the debt in 31 months instead of 118 months and your total interest paid goes down from $779 to $221!

Lastly, make a commitment to yourself, your family and your future to become debt free. Treat this as one of your mayor financial goals to focus in over the next few years. Once you start working towards this, it will gradually become easier even if at the beginning this might feel like a daunting or impossible goal to achieve. Set a target date for when you want to be debt free.

Find some time today to look at the tasks above to complete to keep progressing on your path to Financial Independence!

This post is an adaptation of part 4 of the 10 parts in the guidebook to Financial Independence100 Steps to Financial Independence: The Definitive Roadmap to Achieving Your Financial Dreams where you can find more details as well as action plans and guidelines to each of the 10 parts. Available in both ebook and paperback format!

Get your FREE sample of the 100 Steps to Financial Independence Book here

Coming up next: Part 5 of the Journey to Financial Independence: Your Savings.

 

7 Ways to Invest Some Extra Cash

7 Ways to Invest Some Extra Cash

Last month I received a small bonus from work and after the initial excitement of having some extra money as well as the appreciation and recognition for a job well done, I needed to decide what to do with it, as I didn’t want to blow everything in one go.

How could I make the most of it and allocate it in the best way possible to get bigger long-term results from it? Should I save it, use it to pay off debt, invest it or invest it in myself or my company to generate more income with it?

Here I’ve put together some key points that I hope will be of use to you for when you too find yourself with a little bit of extra money – maybe due to a (small) pay rise, a present or just because you’ve perfected your budgeting skills.

Here are some of the advantages and disadvantages of what you can do with some little extra cash:

Build an emergency fund

What: Save together $1,000 (or the equivalent in your country).

Pros: An emergency fund will allow you to pay for unexpected events without having to go into debt or eating into your savings. I also recommend to build a 6 months living fund with time to cover your expenses for up to 6 months if you find yourself without a job for a prolonged period of time.

Cons: Don’t put more than needed in this savings account, as it will likely not be making you any money due to low interest rates, so once you’ve hit your target amount, put any extra money elsewhere.

Pay off debt

What: Make an extra payment towards your debt, such as a credit card, mortgage or student loan, especially if you have any debts with an annual interest rate over 5%.

Pros: By reducing your outstanding principal, your interest charges go down and so will the long-term effects of compounding interest. The long-term goals of becoming debt-free also means more independence and peace of mind.

Cons: Paying off debt reduces your expenses in the long run, it doesn’t create more money. If you only have outstanding debts with a fairly low interest rate (4% or less), you might get a higher return-on-investment in other ways, such as investing it or generating another income stream with it.

Save

Save money

What: Put the money in a savings account to generate interest.

Pros: It gets you a little closer to your savings goals and it will make you some extra money over time due to interest and most importantly: compounding interest.

Cons: Interest rates are extremely low at the moment and below most inflation rates which means that not only will that money sit idly without making you much money, with time it will also lose value.

Contribute to you pension

What: Make an extra contribution to your private or workplace pension plan.

Pros: By adding more to your pension you’ll not only increase your pension fund, it also allows for it to grow even faster due to increases in returns and its compounding effects.

Cons: Any money invested in your pension plan will not be available until your retirement, you essentially lose access to that money for a long time (or you might be able to take it out before but will need to pay hefty fees.)

Invest in a brokerage account

Invest in the stock marketWhat: Invest the money in your own private investment account to generate interest and dividends.

Pros: Increase your investment funds, as well as the amount of dividends and interest generated to compound without losing access to this money.

Cons: You likely won’t benefit from the same tax advantages that pension funds give and you have to manage your own investments.

Invest in yourself

What: Invest in your individual capital by spending the money on a course, attending a conference or buying books to gain new knowledge or develop your skills.

Pros: Can be tailored to your needs and interest, and can have a long-term effect on your employability, professional development and / or earnings.

Cons: This strategy can be time consuming and prove difficult to see direct financial effect.

Invest in another income stream

Generate another income streamWhat: Set up a company, write a book, buy a property-to-let or find a different way to create another income stream with time.

Pros: Can provide you with a reliable, steady stream of income on the side.

Cons: Can be expensive, hard work, uncertain and unsuccessful.

Which of the above options you ultimately choose depends on your current circumstances: your dreams, plans, job, how much money you have to spend, the risks you want to take, how much time you can and are willing to invest, your family situation and many more. I hope however that the above helps in giving you a better idea of the various options to help you make a decision!

In addition to using your money wisely, if you feel you want to also enjoy a little bit of that extra money now and not just invest it in your future, consider sticking to the 50% rule: invest 50% and keep the rest to spend freely on whatever you want now. Or adapt this to whatever % you want: invest 70% and keep 30%, invest 20% and keep 80%..Whatever you feel happy with!

Day 23 / 31 Should you Invest?

Day 23: Should you Invest?

Day 23: Should you Invest?
Day 23: Should you Invest?

Now that we have covered the basics of investing and the stock market, you might still be wondering whether investing is the right move for you. This challenge starts with looking at reasons to invest, followed by some reasons to hold off investing, after which you should be able to make a more informed decision.

Why should you invest?

Let’s start with some of the main reasons that makes investing worthwhile to many.

  • Investing is an alternative to saving: by setting money aside people hope to grow it and with time build up a nice small capital. 
  • Over long periods of time, the stock market generally goes up. Even if there is the occasional crash when stock prices go down, if you have the time and the patience to sit it out and wait, the market will recover again.
  • On average the markets go up by somewhere between 7-10% yearly. That is more than most yearly inflation rates;
  • The market average is also normally higher than interest rates offered on saving accounts;
  • Another fun advantage of investing: many people like to track their shares and see how they are doing with their investments.

Continue reading “Day 23 / 31 Should you Invest?”

Day 9 / 31 Start paying off your debts

Day 9: Start paying off your Debts

Day 9: Start paying off your Debts
Day 9: Start paying off your Debts

Today’s challenge is to put in a plan of action to start paying off your debts. Now that you have seen how much a debt costs you and how much extra you are paying in interest in yesterday’s challenge, this is probably the best moment to kick those wretched loans to the curb as soon as possible.

Once you start paying of your debts you are beginning to regain control over your financial life, little by little lifting the strain of monthly payments and the psychological burden of being indebted to somebody else. Continue reading “Day 9 / 31 Start paying off your debts”

Day 8 / 31 Learn about Compound Interest

Day 8: Learn about Compound Interest

Day 8: Learn about Compound Interest
Day 8: Learn about Compound Interest

The thing with compound interest is simple: it can either make or break your financial future. That might sound like an exaggeration but it really is that powerful. Today’s challenge is to learn (or refresh your knowledge) about compound interest and see where you have compounding interest affecting your finances positively or negatively.

Compound interest is nothing more than interest over interest over interest. When this happens over any savings or investments you have, this is generally a good thing as it means your capital is growing more each year. Instead of receiving interest over your original amount, you also get interest over any interest you have generated in past years. In this way if you have an investment account with an 8% annual return and an initial starting amount of $10,000 that amount will be worth $46,000 after 20 years. Continue reading “Day 8 / 31 Learn about Compound Interest”

Day 2 / 31 – Calculate your Net Worth

Day 2: Calculate your Net Worth

Day 2 of the 31 Day Challenge to Financial Excellence
Day 2: Calculate your Net Worth

Hello again and great to have you back for the second day of the 31 Days Challenge to Financial Excellence! Today we are going to calculate our net worth to see how healthy (or unhealthy) our current financial situation is.

Your net worth is a sum of all your possessions (also called assets) minus the total of all your debts. You can either have a positive net worth, which means that you have more possessions than debt, or you can have a negative net worth, indicating the exact opposite: you owe more than that you own.

Examples of assets include: real estate, any money in savings or checking accounts, investments and valuables such as antique (don’t bother including your electronics or small jewelry though as these are unlikely to add that much value). Continue reading “Day 2 / 31 – Calculate your Net Worth”

Step 92: Track you progress

Step 92 of the 100 steps mission to financial independence: Track your Progress
Step 92 of the 100 steps mission: Track your Progress

One of the most fun parts of setting goals is seeing yourself getting closer to it with each step that you take. By tracking your progress (and celebrating your victories – something we’ll look at in the next step), becoming financially independent isn’t just a fun end goal, it should can also become a fun journey.

Regardless of your financial goal, whether it is big or small and whether it is a goal for the distant or for the near future, keeping track of how you are doing isn’t just  stimulating and motivating. If you track your progress and keep your tracking somewhere easily accessible and visible, you are also reminded of your goals regularly, which in turn helps you stick to your goal.

Compare the following situations:

  • Situation 1: You decide you want to save $10,000 for a specific goal. The first few days or weeks you feel very motivated and eager to get the money together and you cut out some expenses so you can assign some extra money to your goal. Yet little by little with time you start forgetting about your goal, you stop cutting some of those expenses and within a few weeks you stop putting money aside all together.
  • Situation 2: You decide you want to save $10,000 for a specific goal. You get out a big piece of paper, at the top write: $10,000 for (insert your goal). You decide that for every $10 or $25 you’ll draw a dollar note. You stick the paper in your agenda, on the inside of your bathroom cabinet door or on the fridge. Every time you see the paper you are reminded of your goal and how much you have left to save, which motivates you to take another small step so you can contribute just a little more and draw another dollar note. The more you save, the more motivated you become as you keep seeing the number of dollar note pictures increasing on the paper.

See how different tracking your progress can be in order to actually progress even more and keep up your goal? Tracking isn’t just to see how much you have saved. You can also use this strategy to track how much you have paid off a specific debt. Continue reading “Step 92: Track you progress”

Step 85: Plan your Money Allocation Strategy

Step 85 of the 100 steps mission to Financial Independence: Plan your Money Allocation Strategy
Step 85: Plan your Money Allocation Strategy

A difficult question that many people on their mission to financial independence quickly encounter is “where they should get their money to work for them”: You’ve managed to cut down a little on your expenses, or to up your income or earnings from a side hustle. But the question as to what to do with the extra money you now have remains. Let’s review some of the avenues on how to “make money with your money” that we have looked at on this mission:

  • Paying off debt – saves you money on interest and compounded interested paid over the years.
  • Saving – generates money due to interest received and the power of compounding interest over the years.
  • Investing – generates money due to capital gains, interest received or dividends.
  • Pensions – builds up the income you’ll receive after your retirement age
  • Personal capital – increases your earning potential as a professional or entrepreneur.

These are the most common strategies to pursue in order to leverage what your money can do for you.

But where to start? Say you saved $100 this month and that you are happy to invest this money into your future and future earnings, where do you actually put this money? Which of the above options do you choose? And how do you mix these strategies?

If you haven’t yet fully read the previous steps on the above mentioned strategies, I invite you to read those first before continuing reading this step, to better understand all the pros and cons of each strategy. Just come back once you’re done!

Money allocation

The question of where to allocate your money doesn’t have to imply an “either …or…” situation. You can start investing whilst still having a mortgage. You’ll want to save an emergency fund together whilst still paying off credit card debt. And once you start investing in your personal capital, you’ll likely want to keep that up on a fairly regular basis and the fact that you are investing in the market doesn’t rule out this option. Continue reading “Step 85: Plan your Money Allocation Strategy”

Step 70: Pay off your mortgage

Step 70 of the 100 steps mission to financial independence: Pay off your mortgage
Step 70 : Pay off your mortgage

Now that you’ve been through the various steps on expenses and budgeting, saving, pensions, investing and planning for your future, it’s time to go back again to the bit on debts with one debt in particular which is probably your biggest debt: your mortgage (providing you have one – otherwise you can skip this step). We of course spoke about paying off debt at the start of our mission, but as we said there, since your mortgage has a lower interest rate than most of your other debts, chances are you haven’t yet started paying it down faster.

As commented before many people would argue that a mortgage is a different type of debt and therefore not to worry about as much as they see having a mortgage as an investment. At the end of the day they say, your house is an asset that will probably increase in value over time. I disagree for several reasons:

  •  first of all it isn’t the same type of assets such as stocks and bond that you can just sell to generate some extra money. The only situations in which you can argue that your house is an asset like any other is when you don’t need it anymore for example because you decide to:
    • travel
    • move in with somebody else
    • live in another house that you already own or rent
    • scale down and don’t need a mortgage on a new house
    • live on the streets
  • secondly, you never know when you can sell your house. Some houses are on the market for years, so liquidating that asset isn’t as easy as with other assets.
  • thirdly nothing guarantees your house will truly increase in value or have increased in value by the time you need or want to sell. During the recent house market crash, many houses were sold below their original purchase price.
  • fourthly you are still losing money by having a mortgage in the form of interest payments and you are tied to paying back regularly so until you pay off your mortgage in my eyes this is a debt that takes a big toll on your monthly finances.

Continue reading “Step 70: Pay off your mortgage”