As seen on moneymanifesto.com
If you’re in debt, you’re not alone.
In fact, millions of Americans struggle with debt. The average household owes somewhere between $5,000 – $10,000 in credit card debt alone.
Want to know the largest destroyer of wealth? Well, you found it. Debt.
In my opinion, there are three ways debt should be mentally categorized. Each requires different levels of action. Let’s take a look at them and how to deal with each one.
Value Backed Debt (i.e. Mortgages)
Large purchases, such as a house, are generally an individual’s or couple’s largest lifetime investment and source of debt. However, it’s important to realize it is both an investment and debt.
Included in your monthly payment is the principal and interest you owe on the loan. This kind of debt is backed by something of value.
So, if you want to wipe this debt away, you can pay it off over time or you can sell the item. If the value of the item doesn’t change over its life or it appreciates, then the balance due on the loan can be paid back through a sale.
Not many people have hundreds of thousands in cash to make these purchases so debt like mortgages are carried by millions of Americans. It’s normal and relatively safe.
If you have extra cash lying around it may make sense to invest it, but if the market looks shaky or you want a guaranteed return on your money, put it towards a higher principal payment.
It should be mentioned, of course, you can lose value on the purchase through depreciation or outside circumstances. This is also known as going “underwater” on the loan, causing you to owe more than what your purchase is worth.
The sooner you can get any type of debt out of your life the better. However, this generally doesn’t happen therefore it shouldn’t keep you up at night.
Severity (1-10): 3
Self-Investment Debt (i.e. Student Loans)
Seemingly, one of the main ways to get a solid job is to go to college. Although that is beginning to change, there is almost always value behind education.
Going to college can be extremely expensive, but like the previous category, it is typically seen as an investment. Instead of being a physical item you can get your money back on, the return on investment on self-investment debt is seen in career earnings.
The scary part about loans like this, particularly student loans, is that they will follow you to the grave. Even though the interest rates may not be astronomical, they must be paid back.
Without a physical item to sell and wipe out the loan balance, you need to work and save to pay this back.
There is no easy way out except for old fashioned responsibility. Until it is paid off, self-investment debt will continue to be a sizable liability and will agonize you constantly. Move on it urgently.
My recommendation would be to pay this off before you even begin investing.
Severity (1-10): 6
Consumer Debt (i.e. Credit Card Debt)
We’ve made it to the final level. Consider it to be worse than the plague. Let me just make it crystal clear. Consumer debt is that dangerous. Here’s an example.
Joe recently graduated college and got a job to give him some experience in his field. Unfortunately, it only pays $30,000 per year. Since he just earned a degree and landed a position doing what he studied, he is feeling accomplished.
He wants to reward himself so he decides to go shopping. Joe splurges on some items he has had an eye on since he was 15. For this privilege, Joe now owes $25,000. That’s only slightly less than what Joe will make his entire first year at work.
He decides to use up his life savings of $10,000 for a down payment and takes out a high interest loan on the remaining $15,000.
That loan is to be paid off in 12 months at a 10% interest rate. Since Joe only makes $30,000 per year, he owes over half his salary to this loan thanks to interest payments.
Although Joe has put himself in a tough position, the smartest thing he could do now that he has taken out the loan is to try to live on as little as possible. This will allow him to get that loan paid off in full according to the payment plan.
Sadly, this only leaves him with less than $1250 per month to get by.
If Joe put the balance on a credit card instead, his situation could be even worse. Credit card companies will allow you to leave a generous portion unpaid but then charge extraordinarily high interest rates, think 15% or higher, on the remaining balance.
The interest accumulates until all the debt is paid off. The less you pay off and longer you let it sit, the more you owe, creating a snowball effect. It’s like putting your money in the stock market with guaranteed returns of -20% annually.
Not a great idea.
Let’s say he bought some expensive clothes, electronics, and a vacation with the $25,000. Although there are some “physical products”, they are not something that can be sold back to anyone at nearly the same price, if they can be sold at all.
That’s the differentiation between this type of spending and value backed debt. You should attack consumer debt as aggressively as you possibly can.
By using your savings to pay down consumer debt you may essentially be earning 15-20% returns on your money by paying it off.
In all seriousness, you need to treat consumer debt like the emergency it is. Cut out unnecessary spending. Work a part time job to generate extra income. Sell old items that have value. Rent out an extra room in your house.
The list could go for quite a while. There are an infinite number of ways to make some extra cash. The hard part is forcing yourself to take action.
Severity (1-10): 10
The sooner you fully appreciate and learn to control debt, the more power you have over it and your financial situation. Often it requires nothing fancy, other than working hard and saving.
Achieve the freedom you deserve and lead a stress-free life by getting started today.