Building wealth doesn’t happen for most of us overnight. It’s a lifetime of hard work, combined with good decision-making and self-discipline. It starts early, learning and developing a savings-first mindset.
Accumulating debt is sometimes unavoidable. It can actually be a smart decision to take on some debt, provided the payoff is greater than the cost of the debt.
Take, for example, a family of five looking to find a place to live. Facing the choice between an 800 square foot 2 bedroom apartment with a $1,500 rent payment, or a $200,000 1,500 square foot, 3 bedroom home purchase in an up and coming neighborhood, we’ll probably recommend the purchase. Real estate can be a good investment as homes can appreciate in value. The payoff can be a $200,000 appreciating asset, and a higher quality of living for the family of five.
The point is, debt shouldn’t always be avoided.
When we go through the financial planning process with young families or individuals in their 30s, we often find them trying to pay down debt.
Students graduate with an average of $38,000 in student loan debt. The average household in the United States has $16,061 in credit card debt. Then you tack on a mortgage, perhaps some medical debt, any personal loans, car loans, maybe small business debt, and you find yourself in a position of not knowing where to start. So which debt should you pay off first?
To answer this question, we start with the difference between secured and unsecured debt.
Secured debt is debt that is assigned collateral which allows the lender to claim if the debt goes unpaid. A home, auto, boat or RV are some of the more popular forms of secured debt.
Unsecured debt is debt that does not come with any sort of collateral. Credit cards, student loans, and medical debt are examples of unsecured debt.
The reason we need to establish the difference between those two things is because secured debt is more important to your existence, and therefore, the monthly debt payments should be met comfortably out of your income. We need shelter, we need our vehicles to commute. While the boat and RV may be luxury, you probably want to keep those payments going.
If you are able to meet your monthly obligations on your secured debt comfortably, we often recommend turning your focus to the unsecured debt to pay down first, simply because unsecured debt often comes with higher interest rates. The lender needs to make up for the risk of having no collateral and a higher default rate by charging more for interest.
In some instances we recommend using the debt-snowball method. Start with the loan with the smallest balance. Figure out how to make room in your budget to take a little more on that regular monthly payment to pay it down. Once that loan is paid off, take whatever you were paying on it monthly and use that cash to start paying off the second smallest loan. Keep that pattern going until every last bit of debt is gone.
This is a good idea, and works great for some. Another good concept is to start by paying off the loan with the highest interest rate. This will lead to paying the lender less in the long run, and could lead to a faster debt freedom for you.
Gaining momentum, seeing progress and celebrating your successes (big and small) along your debt-freedom journey is key to keeping yourself going.
Don't become so focused on which debt to pay off that you become complacent in your journey. Debt freedom is possible with the right mentality, discipline, and behavior.
Debt is often unavoidable, but building wealth becomes easier when your monthly cash flow can be used to save rather than pay a lender. To reach the Summit, you first need to climb your way out of the valley. You can do it, and we are here to help!
Sources:
https://www.discover.com/credit-cards/resources/average-credit-card-debt/