MoneyMonday: Living Debt Free

Welcome to this workshop, Living Debt Free. Tips and tricks for eliminating debt. I’m Janel Cross, one of your MoneyNav coaches.

We think of your financial life as unfolding in three stages. The first is Financial Safety with a focus on building a solid foundation. Next is Wealth Accumulation where we gather resources for the final stage, Financial Freedom where we have the money, we need to do things that bring joy and fulfillment to our lives. For more on the money stages, check out our Money Milestones course which takes a deep dive into each stage.

This session is a stage 2, wealth accumulation course

From 2010 to 2020, we saw the highest-ever annual increase in total outstanding U.S. consumer debt. Of course, we have a global pandemic to thank for much of that, but household debt has been growing for a long time. In fact, since 2010, consumer debt has increased by over 30%.

Obviously, debt takes a financial toll, but it also takes an emotional toll that is just as bad. So, eliminating debt is not only about healthy finances but also healthy lives. But is it even possible to live debt-free? Yes! It’s possible! But before setting a goal to live debt-free, you must complete foundational financial steps like…

establish an emergency savings account with a minimum of $1000. Then begin working toward saving enough to cover your living expenses for 3 months, and create a spending plan. If you don’t know what you’re spending, you can’t know how much extra you have to plow into your debt-elimination plan.   secure basic insurance coverage and get started saving in your 401k. When you have extra dollars after addressing these essentials, it might be time to put dollars toward wiping out debt.

The steps to living debt-free are simple, but that doesn’t mean they’re easy. First, stop digging deeper. Create a spending plan and stick to it. Next, start climbing out. We will talk about two methods for paying down debt, the snowball method and the avalanche method. Then, take steps to avoid falling back in. The key here is having a healthy emergency savings account. Then it’s time to dream big. Imagine the time when your debt is gone. What will you do with those extra dollars?

First, you’ll need to know the difference between good debt and bad debt.   Next, what about interest rates? And third, determine what debt elimination method is right for you.

First, not all debt is created equal.   Good debt is when you borrow money to purchase items that increase in value over time. When used properly, good debt can help you build your wealth. Good debt includes things like your mortgage and student loans. Also, good debt tends to have lower interest rates than other types of debt.  

By contrast, bad debt is when you borrow money to pay for things that lose value over time. This type of debt typically has higher interest rates which can have a negative impact on building your wealth. The most common type of bad debt is credit cards which we tend to use to buy things we want but may not necessarily be able to afford. Technically auto loans are under bad debt too but since transportation is necessary for getting to work and earning a paycheck, you can think of this in the “less bad” category.

Different types of loans have different interest rates. While you carry a balance, whether it’s for a loan or a credit card, you must pay extra each month based on the interest rate. For example, the average student loan interest rate is about 6%. But for credit cards, it’s often much higher.

And the interest rate impacts the cost of paying back the loan…

A $15,000 student loan balance at a 6% interest rate will be paid off in 5 years if you pay $290 per month. Over the life of the loan, you’ll pay $2,400 in interest.

A $15,000 credit card balance at a 15% interest will be paid in 5 years if you pay $357 per month. But you’ll pay over $6,400 in interest.

credit score also influences your interest rate. In our Understanding Your Credit session, we take a deep dive into what goes into your credit score and how to improve it.

For now, we will just focus on your credit rating which ranges from bad to excellent. And depending on where you fall on the spectrum, you may pay a higher or lower interest rate than someone else.

For example, to pay off a $300,000 mortgage in 30 years, a person with acceptable credit might pay over $330k in interest. But a person with excellent credit, who is offered a lower interest rate, might pay over $100k less on the same loan.

Similarly, paying off an auto loan might cost the borrower with acceptable credit almost, $2400 more.

Now that you know the difference between good and bad debt and understand how interest rates factor into the cost of paying off the loan, it’s time to start climbing out.

The most important factor in managing debt is motivation. And, as with most things, we are each unique in what motivates us. There are two common approaches to paying down debt. They are the Snowball Method and the Avalanche Method.

In the snowball method, you pay off your smallest debt first which is great for folks motivated by “small wins” or “checking things off the list.” Organize balances from smallest to largest. Make the minimum payment on each card. Make an additional payment on the smallest balance. When you pay off that card, add its minimum payment plus the extra payment to the next smallest balance.

In the Avalanche Method, gratification is less immediate. You focus on the debt that has the highest interest rate which may also be the highest balance. Pay off that high-interest debt as quickly as you can. When the highest rate debt is paid off, apply the additional payments to the debt with the next highest rate.  

This method motivates folks focused on the big picture – in this case paying the least amount of interest over time. But progress is slower. So, as long as you can stick with it, the avalanche method will have you paying less interest overall.

Regardless of the method you choose, you’ll need to create a list of your debts. Include the type of debt, the total balance, the required monthly payment, and the interest rate.

If you’re using the snowball method, arrange the list by smallest to largest balance. If you’re using the avalanche method, arrange the list from highest to lowest interest rate. Then let the debt elimination fun begin!

A question we are asked is whether 0% balance transfers work. The answer depends on your personal spending discipline. If transferring a balance to a card with a lower interest rate tempts you to pile more debt on that now empty card, then the balance transfer isn’t a good idea. But if you cut up that other credit card and refrain from incurring new charges, then go for it!

Note that most balance transfers have a transaction fee. For example, they might charge 3% of the balance transferred before they offer that 0% rate. This balance transfer fee gets added to the amount you owe. So, make sure that fee is worth it. If it’s a small balance with a 5% interest rate that you could pay off soon, it may not make sense to pay a 3% transfer fee.

Another question we are asked is whether to makes sense to refinance a loan. While it’s tempting to make this decision all about the payment, if you’re focused on dollars and cents, you’re going to have to dig a little deeper.

In my experience, few people take time to “do the math” and even fewer lenders volunteer the necessary information.

When you refinance a mortgage, for example, there are significant closing costs involved. In most cases, those closing costs are rolled into the new loan which increases the balance you owe.

If you are reducing the term, or length, of your loan, your monthly payment may increase. To figure out if the new loan is better than your current one, you’ll need to run some amortization calculations. This will help you figure out if you’re better off paying the costs to get the lower interest rate or if you should simply make extra payments on your current loan.

This can be tricky math. But remember, your MoneyNav coaches are here to help. Just sign up for a 1-to-1 coaching session so we can help you evaluate your options. We also have a workshop called, Buying, Renting, and Refinancing that provides more information on this topic.

Consideration that might make a refi more valuable is if you plan to do a cash-out refinance. In this transaction, you cashout some of the equity you’ve accumulated in your home. While this does increase your mortgage balance, this can be a good debt management strategy if you’re using that cash to pay off higher-interest debt.

Here again, though, just like those credit card balance transfers, you need to make sure you have spending discipline. If you cash out some of your home equity to pay off credit cards only to accumulate more credit debt… well, then you are worse off than if you had not done the refi at all.

So, as we wrap up, let’s review our four steps to eliminating debt…

Step 1: I stop digging: create and follow a spending plan, make a list of your debts, and assess what motivates you – small victories or saving money in the long run.

Step 2 start climbing out: build either a snowball or avalanche debt elimination plan. Make extra payments accordingly and as you payoff one debt, take that payment and apply it to the next. Be sure you continue making on-time, minimum payments on all debts to protect your credit score. And, while you’re at it, look into ways to reduce your interest expense like credit card balance transfers, loan consolidation, and mortgage refinance options. If you’ve been making on-time payments, don’t hesitate to call the lender or credit card company and ask for an interest rate reduction. It won’t happen every time, but it doesn’t hurt to ask.

While making progress is good, making sure you don’t back-pedal is just as important. Build that emergency savings account. We can’t stop life from throwing curve balls and we can’t predict the future. So, preparing to deal with an unexpected financial emergency is just as important to living debt-free as making extra payments on your credit cards.

And so is visualizing the finish line by dreaming about what you’ll do with those money resources after your debts are paid off.

Paying off debt is hard. Which is why rewarding victories are critical to staying motivated and on track. If you’ve gone three months without using a credit card, celebrate in some way. If you’ve paid off a credit card, reward yourself. Even better, take the journey with a friend so you can motivate and celebrate together. Your MoneyNav coaches are great for this too!

Tackling debt is a big undertaking but taking the first step is easy. There are lots of debt management resources at moneynav.com and, of course, your MoneyNav financial coaches want to help you too.

If you haven’t already kicked off your MoneyNav journey, do it now. A great next step is to complete your MoneyNav assessment. This questionnaire takes about 5 minutes and results in a series of Money Moves, or best next steps, built into your personalized MoneyNav dashboard. Email yourfinancialcoach@moneynav.com for a link.

And we hope you will continue to join us here for MoneyMondays. Visit www.moneynav.com/moneymonday for a list of sessions and to sign up. If you join MoneyNav on Facebook, Twitter, and YouTube, you can stay up to date with notices of upcoming sessions and links to the video after.

On behalf of the entire MoneyNav team, thanks for joining me today! If you have questions on this topic or another, please reach out. We look forward to connecting with you.