If you are debt free, you can skip this post entirely. The purpose of this post is to allow readers to begin with a negative net worth and begin thinking of complete financial independence. We are not negative people and believe many citizens simply had bad life events occur that forced them into a large debt load – a medical expense, a large recession with a medium sized debt load, etc. With that said, if you are in debt you need to sit down stop everything you are doing and find ways to become debt free. Today.
Math Behind Debt: We will refer to this concept many times but you must think about money in percentage terms. Compounding is a powerful mathematical fact of life. As a simple rule of thumb if you take the number 72 and divide it by your annual return rate, say 10%, you now have the number of years it will take for your money to double (7.2 years).
The problem with debt is you are working in the other direction with this compounding issue. Assuming you have a relatively low interest rate at 5% that still means you will owe an extra 63% in just 10 years if you are not paying down your debt. In short, debt is a financial disaster, your entire portfolio and future net worth is burning down, you need a solution today because this is a code red financial situation. With that said lets take a look at how you can go about taking down your debt load.
Worst Case High Credit Card Debt No Payments
As soon as you are able to save some cash get ready to delay payments and make a one time pay off of your debt. Yes you read that correctly. Assuming you have a high debt load (we will use $10K in debt as a simple numerical example to make the numbers easy) you want to do is delay payments until you are allowed to have a portion of the debt forgiven. Here is a practical example:
Joe: Owes $10K in credit card debt, making no payments and now calls in to settle his debt. They agree to forgive $5K of the debt. In this situation Joe can now take down his debt substantially. You will need to pay taxes on the forgiven debt (5K*income tax rate lets say 25%) or $1.25K + $5K remaining debt. You have now taken down your debt by $3.75K or 37.5%! Remember to think in percentage terms that is quite a large return profile. Make the full payment and wipe it off the books.
Be sure to carefully go through this route with a debt settlement agency as you want to do anything and everything to get your credit score back up to normalcy. Notably, if you do not pay your bill for 9 months straight it becomes a red flag on your credit report for ~7 years. Finally, when you pay off the debt in full be sure to keep your paid/settled in full letter from the creditor.
Essentially, in a high debt, high interest rate situation you will likely be better off going down this route. This is certainly not an ideal financial situation and we would never advise anyone to put off paying bills but many people are stuck in this situation today and simply cannot make minimal payments. As a decent guideline, if the creditors are calling you in a nice tone, you’re likely in a position to fight for a settlement.
Note On Settlement Tips:
1) Call one day before the end of the month, the last collection day coincides with the final day in addition try to get the payment at 50% or below, start with a low settlement rate of 20% or so.
2) Attempt to get a cease and desist for phone calls and request communication in writing, this is good for about 7 days and if they break the rule you may sue the company, they will likely settle your account
Average Scenario Small Level of Debt
Many Americans today have a small level of credit card debt which should be addressed according to their current savings rates. Assuming you are gainfully employed the calculation again comes down to percentages.
Calculate the Return: Lets assume you have a credit card statement that has a 5% rate. You have to decide between your 401K, credit card payments and of course regular living expenses. Here’s the trick, you should actually max out your match and then use the remaining money to pay off your debt. Here’s the flow chart
Company Match (100% returns) -> Credit Card Payment (5-10%) -> Save One Month of Living Expenses -> Investing (7% returns)
Why are we saying to use the company match? Again the answer is in the percentages, a company match is an immediate 100% gain. If you put $100 in you now have $200. Instead of paying off your 5-10% debt you’re getting a 90-95% immediate return profile.
Tiering Debt: If you have a few layers of debt you may want to make the minimum payment for certain notes. As a practical example lets take a look at the current structure:
Joe $4000 in debt:
1) $1000 debt at 7%
2) $1000 debt at 10% but 0% for 9 months
3) $1000 debt at 4%
4) $1000 in debt at 1.5% (student loan)
In this situation you first pay off the 7% debt (highest return), then begin paying off the 10% debt until the 9 month period is over, then pay off the 4% debt. However, you should leave the $1,000 debt payment at 1.5% untouched because it does not keep up with inflation. This means you are actually making money by reinvesting your cash into 4-7% bond and dividend paying funds.
In simple terms, if your debt load is not outgrowing inflation there is no need to pay it down. Notably, most interest rates will force you to pay off the debt load so be sure to again run the numbers on a percentage basis. Once your cards are taken care of be sure to move onto recycling them.
