Well, not all debt just sucks… just most of it. Debt setup badly can feel like it’s sucking the life out of you – as if the walls are closing in and you’re desperately trying to make it out the other side. Debt setup well can allow you to buy a home, invest in further assets and build a strong financial future.
Debt falls in to two really broad categories – deductible and non-deductible.
Deductible debt is debt that you can claim the interest as a tax deduction, usually because you’ve used the money to invest in some form of shares or property.
Non-deductible debt is all other forms of debt that don’t provide any tax benefits – credit cards, payday loans, car loans, personal loans money you owe relatives, your home loan etc.
Though the dream is to be debt-free at some point, deductible debt is far better to have than non-deductible debt. Deductible debt means that you’ve borrowed money to invest, sacrificing now to be able to provide for the future. Non-deductible debt usually works in the opposite direction. It means you’ve borrowed money from the future, to be able to live a certain way now.
So, how do we get rid of those non-deductible debts?
The first thing to do is embrace that you’re robbing from your own future and you need to stop. Debts like credit cards, payday loans and personal loans give you money now, at the cost of much more money later. Once you’ve settled that, you’ll have to find a way to start living within your means – either by increasing your income, decreasing your expenses, or ideally both. Once you’re living within your means, you can start paying back the principal on your loans with every spare dollar you’ve got.
If you’ve got multiple debts and aren’t sure what to pay first then there are two options. One is called the debt snowball, the other is the high-rate method.
Let’s assume you’ve got the following debts:
$300 payday loan @ 20% interest
$750 credit card @ 13% interest
$3,000 personal loan @ 15% interest
$7,000 credit card @ 22% interest
$15,000 car loan @ 9% interest
Take all of your debts and line them up in order of smallest balance to largest balance. Take every spare dollar you have and known off the smallest debt. Then take those same spare dollars, plus the amount you were paying on that smallest debt, and put it into the next debt. Repeat until all debts are paid off. As you knock over each debt you will free up a little more cash to be able to knock over the next one. This creates the ‘snowball’ effect. This method isn’t necessarily the most efficient way to repay your debt, but the emotional boost and sense of accomplishment watching those debts clear is so encouraging and will help you stay the course. By knocking off your $300 payday loan, then your $750 credit card then your $3,000 personal loan you’ll have the confidence and courage to pay down the bigger $7,000 and $15,000 loans.
Logically the best way to get out of debt is to pay down the debt with the highest interest rate first. The higher the interest rate, the more the debt is costing you over time. This is the best option if you’re a highly logical person with good discipline as it will get your out of debt fastest. Eliminating the debts by interest rate will save you the most money over time, but it can be hard to stay focused if your highest rate debt is also your biggest debt. The challenge here is that the highest interest rate is the $7,000 credit card. Trying to pay down this credit card first can feel like trying to walk before you can crawl. If you can do it, it’s the best way forward, but it’s not for everyone.