Personal Finance/Paying Debt

OK, so now you are living cheaper and as a result have some extra money left-over from your immediate survival-based monthly expenses. Time to slay the Debt Monster... or is it?

One important decision to make is where to allocate the extra 50$ you made. Will it go to pay down debt or will it go to savings?

Money has momentum. This is why the rich get richer and the poor get poorer. Money's momentum is exponential as a result of compounding interest.

If you have 100$ of savings at a 10% interest rate, it will not take 10 years to grow to 200$. It will take 7.2 years.

Likewise, if you have 100$ of debt at a 10% interest rate, you will owe 200$ in 7.2 years if you don't repay your debts. Only repaying the interest will keep you in poverty forever.

We arrive at these numbers using the "72 Rule", which is simply to divide 72 by the percentage of interest you have to see how many years it will take to double your capital. So, debt at 12% will double in only 6 years. Credit card companies get rich by having you pay only the minimum on your card. A future chapter will deal exclusively with credit cards but let us just say that the minimum payments are designed to keep you indebted (and thus paying) forever.

So, money that has to go to repay debt is money that is not working towards making you richer. To decide whether to repay debt or invest, consider the rates on both propositions.

If you can invest your money safely (ie: NOT stocks, options, commodities, baseball cards or other 'risky' investments) at a higher interest rate than your debts, you might consider investing the money and using the spread between the money you make and the money you lose to pay your debts. (This is the idea behind margin, which we will get to in time.)

For example, if you can make 5% interest on 100$ using a safe investment which you understand but your 100$ debt rises at a rate of 12%, you are better paying your debts before worrying about investing. You will "save" 7$/year by paying your debts rather than investing.

If, as in the 1980's, you had interest on a 100$ 5 year CD at 12%, investing in that safe vehicle might have been better than paying down the 100$ debt owed to your mom and dad at 5%. In this case, your spread would be 7$/year. In this case, that's REAL money in your pocket which you can then put down on debt or again on investment.

In today's low rate, high stock PEs and potentially inflationary environment, finding a safe investment that will return more than the interest rates of your debt will be challenging to say the least. It may then be far better to simply pay down your debt and make sure that it doesn't come back anytime soon.

How do you pay down debt?Edit

Firstly, you need to itemize your debt. Make a list of all of your debt and the rates on each type of debt. This should include credit cards, mortgages, student loans, money owed to your parents, car loans etc.

Here is an example (If someone has actual debts, feel free to replace my fictitious example with a real-life one.)

Debt name Debt amount Interest rate
Mastercard 100$ 12%
Mortgage 100$ 3%
Car loan 100$ 7%
Student Loan 100$ 2%
Visa 100$ 16%
Mom and Dad 100$ 0%
DIC card 100$ 28%

To put this into perspective, 700$ of total debt will generate 68$ of extra debt per year. Nearly a 10% average rate!

Not all debt is equalEdit

Some of the debt in this example has little momentum and some has tremendous momentum! When you decide where to put your 50$, pay off the minimums on everything to keep up your credit score. After paying the minimums, put EVERYTHING on the highest rate debt, the DIC card at 28% in this case. Deal with it item by item, as you slowly get out of the debt pit.

Don't add to your debt!Edit

Just as important as getting rid of the highest rate debt first, so is not adding more fuel to the fire at your feet. Stop using your cards! If you can't pay for it in cash, you cannot afford it (today). Wait until it's on sale or until you accumulate enough cash to pay for it, or better, both! Basically, if you have a mountain of debt, you got here by living above your means and as long as you continue to do so, the mountain of debt will not shrink and disappear. You will be a slave to your debt forever.

Again, kill the debt one bit at a time and don't let it grow back. Burn your cards if you have to.

Last modified on 7 October 2010, at 20:33