Avoiding debt entirely is nearly impossible, nor is it recommended. However, there are certain pitfalls of debt that must be avoided if you wish to achieve your financial goals. In this article I will explain the basics of debt, the difference between good and bad debts and how to get out of bad debt quickly.
First a quick definition of what exactly is debt. You accumulate debt by borrowing money from someone else, usually a bank or some form of lending company. In return for having access to money now, you in turn need to pay back the amount with some interest. Debt is kind of the opposite of investing into fixed income investments such as bonds, where you give your money to someone else in return for interest. Your total debt is the amount of money that you owe to all institutions, governments, companies, and private individuals.
Good Debt vs Bad Debt
There are different kinds of debt and different reasons for which to be in debt. As a rule of thumb, the following applies:
|Low Interest Debt||High Interest Debt|
|Debt for Investment Purposes||Debt for buying luxuries wants|
|Debt for education||Debt for a luxury car|
|Debt for a Home (low interest mortgage)||Long term Credit Card Debt|
Getting a low interest mortgage for you home is pretty much one of the only ways to afford a house in time for your family. Accumulating that much cash for a house by 25/30 years old is near impossible. Also, I don’t recommend paying a house fully by cash, as a mortgage is just too good of a deal to pass up with the lowest interest rate you’ll ever get. While mortgage calculators are great at showing you how much you save in interest by paying it earlier, what they don’t show is the opportunity costs of paying it later and investing that extra money instead.
Accumulating debt for education is a great investment as long as you are studying in a field that will lead to a high paying job. Accumulating debt for education on a subject that won’t lead to a well-paying career is not a good investment. Do your research on the career prospects of your chosen studies before you go into debt for it.
While I do explain in my article Top 5 Benefits of Credit Cards the main reasons I much prefer to use a credit card over paying cash, I cannot state enough how important it is to pay your monthly statement in full each time. That way you don’t pay a cent of credit card interest. Credit card interest is one of the highest cost debts out there and one of the worst kinds of debt. Only use a credit card if you can promise to yourself that you will pay it off in full prior to each statement due date.
To summarize, only take on low interest debt for education, home buying or investment purposes. If you are borrowing to invest, be sure your return on investments has a strong chance of outperforming the interest rate of your debt.
Getting Rid of Bad Debt
Maybe you already have accumulated some bad debt in your life and are reading this article looking for ideas on how to get out of it. Well the first thing you need to do is make it a priority for your financial future that you will make efforts towards eliminating this bad debt.
Step 1: Transfer all high interest debts to lower interest debts
You can’t make your debt disappear instantly, but you can minimize the amount of interest you’ll be paying on it. Lines of credits, especially those against a home, often have the lowest interest rate loan that you can quickly apply for from your bank. Take a line of credit out for what you need and use it to fully pay off credit cards or other high interest loans. Now all your debt is in 1 place with a better interest rate.
Step 2: Make an aggressive pay back plan
Set yourself an objective of how quickly you want to pay back this debt. The higher the interest rate the more aggressive you’ll want to be. If a home line of credit has a very low interest rate, you can get away with taking a slower approach while maintaining your commitments to your retirement savings.
Step 3: Spending Cuts
It’s time to take the axe to all that unnecessary spending. You’ll want to reduce your luxury spending in order to meet your debt payback goals. Check out my articles on effective spending I and effecting spending II for more tips on how to go about this.
Step 4: Track Your Progress
Now that the plan is in motion, it is time to implement and track your progress. I find it always more motivating when I create a quick spreadsheet to track my goals over time. Gives me the extra motivation to stick with the plan.
You must stay strong and resist the temptation to spend even if it may seem rough at times. Just remember that taking on more debt now will only hurt you many times over in the future.