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.