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?
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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.
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!