“A bank is a place that will lend you money if you can prove that you don’t need it.”
– Bob Hope
A lot of people seem to think that credit caused the recent financial mess and that cash is king. While part of that might be true, things are not so simple. Debt can be good. In fact, as long as you’re using it correctly, debt can be used as a tool.
Credit cards can also be a great way to keep track of your spending and get rewarded for making purchases you would make either way. With some offers, what you earn in cash back and loyalty rewards will more than make up for the annual fee!
This is why we need to distinguish between good debt and bad debt. Good debt (e.g. debt used to buy investment properties) puts money in your pocket. Bad debt (e.g. debt from buying junk on credit) makes you broke. Although each situation is different and good advice from a financial planner is always advised, these three tips are a good starting point.
1. Control your spending
With over $800 billion in outstanding credit card debt and $45 billion spent over the 2010 Thanksgiving weekend, it’s clear we love to shop! But does it make sense to keep digging when you’re already stuck in a hole? Of course not!
Don’t buy luxuries on credit or spend more than you earn (like almost half of all households do). Instead, learn to delay gratification. To be financially free, you must focus on building assets. Once those are generating sufficient passive and portfolio income, you can have all the toys you want.
“He who covets is a poor man, because he wants what he cannot get; but he who has nothing and covets nothing is rich, though you may think him no more than a peasant.”
– Geoffrey Chaucer
2. Pay off your credit cards
Spend time online searching for the best credit card deals. Don’t be afraid to call the company you’re with and ask if they’re prepared to lower your rate or waive the annual fee. Some of them are more than happy to do so rather than lose you altogether.
If you’ve found a good deal that isn’t a temporary promotional offer and has no transfer fees, consolidate your debt. Then proceed to pay more than the minimum amount due every month (which shouldn’t be too hard now that you cut back expenses in step one). If you still pay the minimum, youíll be in debt forever.
You must get rid of credit card debt even if this means tapping into your rainy day reserve (which you will replenish later). It makes no sense to have a stash of cash sitting in a savings account earning 2% interest when you’re incurring ten times that amount on credit card and other debt.
A lot of people don’t make the connection that increasing income (in a savings account) and decreasing expenses (on your debt repayments) are the same thing. They get stuck in what behavioural economists call framing (viewing the same thing differently just because it happens to be phrased a little odd).
If consolidation doesn’t work, there are other options. Start by focusing on the credit card that charges the highest interest rate. Again, use the extra money from cutting back expenses to make sure you pay more than the minimum amount each month. Once the first card is paid off, transfer the full amount you were paying to the next card so that your payment will increase.
For example, if the minimum on the card with the highest interest rate is $100 per month and you can spare an extra $20 per month, you’d pay $120 per month. Once this card is paid off, youíd add the $120 to the minimum on the card with the next highest rate. This process would continue to snowball until all your credit card debt is paid off. Yes, it may take some time, but it will be worth it in the end.
From here, you would close all your credit cards (except for one or two that youíd continue to pay off IN FULL every month). The money you were using to pay off your credit cards could now go back to your building up a rainy day reserve, opening an investment account, or reducing other bad debt.
3. Pay off your mortgage (or not)
With only 2% of homes paid for, 1 in 4 mortgages greater than the value of the property, and foreclosures at all-time highs, paying off your home as quickly as possible sounds like a great idea. But this isn’t always the case.
If you have an excellent credit report and qualify for a low mortgage rate, you may be better off investing the additional funds in an asset that will provide a higher return. In other words, the asset will pay your mortgage for you.
But if your mortgage rate is high, it might be better to sell an investment offering lower returns in order to pay it off. Much like with high interest credit cards, you forget about having an emergency fund because your home equity line of credit fills that role.
Obviously, this means that whatever would have gone into your savings account must go into your home. Blowing it elsewhere defeats the point (and is the reason so many people got into trouble when house prices came down).
Ultimately, it comes down to numbers. Earning 5% income on an investment makes no sense if you’re being charged 10% on your mortgage while forgoing 10% on an investment makes no sense just to pay off a mortgage at 5%.
If the mortgage rate is higher than the investment rate, put the money in the mortgage. If the investment rate is higher than the mortgage rate, put the money in the investment. Go where the numbers lead you.
A great way to pay off your mortgage faster than schedule is to pay your installments once a week instead of once a month, effectively resulting in an extra payment each year.
For example, instead of paying $1,000 per month, you pay $250 per week. This means that instead of paying $12,000 per year ($1,000 x 12 months), you pay $13,000 per year ($250 x 52 weeks). The extra $1,000 amortised to your mortgage means you pay it off sooner. Doesn’t that sound doable?
Eugene Yiga writes at his personal development blog VarsityBlah.com. For more information on the services he provides, email Eugene at firstname.lastname@example.org.