4 Steps to Finally Tackle Your Debt—and Start Growing Real Wealth

by | BiggerPockets.com

Debt can be a heavy, scary beast riding around on your shoulders. Live with debt long enough, and it can start to stoop your shoulders and droop your eyes.

That begins to change on the day you decide you’ve had enough. The day you throw the beast off your shoulders and give it a running start, warning “I’m coming for you,” you’ll feel instantly better.

Sure, debt has its uses. Even the most novice of real estate investors understands the value of leverage. But let’s nod to Robert Kiyosaki and acknowledge the difference between good debt and bad debt. Bad debt makes you poorer—it costs you money every month. Examples include your car loan, your credit card balances, and personal loans.

Good debt makes you richer—it helps you earn money every month. The best example is a mortgage on a rental property with strong cash flow; because you borrowed money, you were able to add $500/month in passive income.

But we’re getting ahead of ourselves. First and foremost, how do you start digging yourself out of bad debt?

Step #1: Start with an Automated Budget

We’ve been over budgeting before, but it’s integral to any conversation about paying off debts.

Most budgets fail, despite their creators’ best intentions. They fail because people rely on willpower, leaving it up to themselves to “do the right thing” and not overspend.

If you want your budget to work—not just this month but every month—you will need to take away your ability to overspend. Remove failure as an option.

Start by calculating your monthly debt payments. Next, commit to an additional amount that’s a bit of a stretch but not unbearable. Add the two together: This is your investment toward paying off your debts.

Then have that money go directly from your paycheck to a savings account. If your employer’s payroll can split your direct deposit, great. If not, set up recurring transfers from your checking account to your savings account on the same day you get paid.

Then, take your credit card out of your wallet and leave it in a drawer at home. You may not spend more than what’s in your checking account. Period.

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Step #2: Prioritize Higher-Interest Debts

Money is now arriving safely in your savings account every time you get paid. Awesome! So what do you do with it?

Start by paying all of it toward your highest-interest debt. For most people, that’s their credit card debt. Your other debts can wait—just make the minimum payment on them.

These payments should also be automatic and scheduled to recur on the same day you get paid. In the beginning, no money will accumulate in your savings account. You should have a permanent balance of around $0.17, because as soon as money goes in, it goes right back out to your debt payments. That’s okay for now.

The important thing is you’re now putting a serious dent in your debt, every two weeks (or however often you’re paid).

Step #3: Snowball Your Payments

Woohoo! You paid off your credit card! Now what?

After a good ol’ pat on the back, it’s time to update your automatic payments. You get to scale back on the savings now that you have less in debt payments, right?

Nope. Nein. Forget about it. We’re staying the course.

Now that your monthly debt payments are that much lower, you can throw that extra money toward your next highest-interest debt. You’ll pay that one off even faster since you’re able to pay more money towards it every two weeks.

When that second debt is paid off, repeat the same process of funneling that much more money toward the next debt. So, your personal budget remains exactly same, and the portion of your paycheck that goes towards paying debts also stays the same, but as you pay off debts, you’ll be able to concentrate more and more money toward each remaining debt.

But not all debts are created equal, and some may be worth keeping. So where do you stop?

Step #4: Decide When to Stop Paying Off Debts & Start Investing

All credit card debts should be paid off, as should any other debt over 8% interest. When you get down to debts below 6-8%, suddenly it becomes a judgment call: Can I reliably earn more from an investment than I’m paying for this debt?

Historically, the stock market yields 7-10% returns on investment. Real estate can earn substantially higher returns for experienced investors. But investment returns are not a sure bet—they’re mere projections. Paying off debts provides a guaranteed return on investment.

If you have doubts about your ability to invest for higher returns than a given debt’s interest rate, pay off the debt. For example, I know I can earn better returns for my money than the 4% interest I pay for my home mortgage. So I only make the minimum monthly payment on it, and I invest my savings elsewhere.

But the most important part is continuing to have money redirected from your operating account to go out working for you. Even once you’ve paid off all of your expensive debts, don’t cut your savings rate—start investing with it instead of paying debts!

Acquisition Cycles & Defensive Cycles

Even good debt has its downsides. Borrowing money to buy a rental property may help you acquire it in the first place, but from that day forward, it eats into your cash flow.

Think of leverage as a means to acquisition, and consequently paying off that debt as a means to multiply your passive income. If step #1 is “borrow to acquire,” consider that there is a step #2: “pay off the debt.”

While I would never recommend that anyone try to time the market, everyone goes through times when they feel good about actively investing money—and other times when they feel more conservative. Real estate cycles are much longer and slower than, say, stock volatility. You can decide as an investor if it’s a good time for you personally to add more rentals to your portfolio or pay down the mortgages on existing properties.

In a perfect world, you’d buy, buy, buy when markets have been low (e.g. 2011) and then stop when you start feeling overexposed. As a defensive “investment,” you can then pay off your mortgages, one at a time, just like you did with your personal debts.

But ultimately, choosing what to do with your saved money isn’t the crux of the matter. Committing to a savings rate and maintaining discipline against lifestyle inflation—those are sturdy bricks on the road to financial independence.

And tips and tricks that have helped you stay on budget and knock out debt?

Let me know with a comment!

About Author

Brian Davis

Brian is a real estate investor and landlord with 15 rental properties, who writes fascinating articles for SparkRental.com. His rental management is almost completely automated by now, allowing him to travel the world frequently (if not always in style).

7 Comments

  1. Krista Riggs

    Not getting into bad debt in the first place is best ! For anyone struggling with budgeting and debt out there I’d recommend reading ‘your money or your life’. You can’t set a budget without first finding out where your money is going in the first place, dig up the last 6 months of expenses and see where you can make changes.

  2. Jerry W.

    Another way to limit the money you spend is get out a set amount of cash, and put a sticky note in it for each week you will be using that money until your next paycheck. Taking cash out of your pocket and spending it can really deter you from big impulse spending. You can even keep the money in your drawer and only take a days worth, or a weeks worth of money in your pocket. Sometimes you can save some cash out of your allowance and keep an extra amount of saved cash for special occasions. I started taking cash out of each paycheck and save as much as I can to use for earnest money on offers on property. Of course the realtors hate taking cash for earnest money, wow.
    I also had one debt I was really worried about that had a big balloon payment coming due on it. (The seller had financed the 20% down payment for the bank loan at 2%) I started adding $200 per month to the payment a few years ahead of when it was going to have the five year balloon payment come due, so when it got close I did not actually have to refinance the property to pay the balloon payment off. That felt really good.

    • Brian Davis

      I’m a huge fan of the all-cash diet for anyone struggling with getting the budget under control.
      By the way, that’s great you were able to pay that mortgage off entirely in five years, before the balloon came due! Refinancing is expensive, and starts your amortization schedule all over again with the high-interest payments. Great job planning in advance for that!

  3. Willie Jenkins

    If you’re discipline, yes your 4 step to finally tackling your debt works. With your 4 steps process you never mention what happens if there is an emergency like the transmission going out. You see, with your 4 steps, once you put the credit cards away and make the payments the money is gone (one way street). There is no way to get it back without pulling the credit card out again.

    There may be a better way for some. Like using velocity banking (using the banks money) to accelerate your debt reduction. Yes you heard me correctly – Use the banks money to accelerate your debt reduction. By using velocity banking your funds are always there for you (two way street). Velocity bank is a two way street, where as the 4 step process you have mentioned is only a one way street.

    Yes I show entrepreneurs and employees velocity banking, how to use the banks money to accelerate their debt, so that they can keep more money in their pockets and take longer vacations, that wouldn’t interest you would it ([email protected])?

  4. Kevin McLaughlin

    One caveat to setting up the savings account – you are usually only allowed 6 withdrawals per cycle (I believe by law). I have the ability to split my paycheck multiple ways, so I have enough to cover the mortgage to to an account at Wells Fargo, the car payment to an account at the credit union, etc. Takes a little more work to set up, but once you do it, you never have the temptation to dial back a little to splurge.

    But it is depressing to see that small deposit to my day-to-day checking account!

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