Milestone 3: Pay Off Toxic Debt
By now you should have completed your budget, saved at least $1,000 in cash, begun taking advantage of your employer’s matching dollars, and are ready to move on to Milestone #3: Pay Off Toxic Debt.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
Debt is an interesting financial topic that generates a wide-reaching variety of opinions about what is and isn’t constructive.
Some despise it entirely and believe one dollar of debt is a dollar too much. Others embrace leverage like it’s the very air they breathe.
Both extremes have their own pros and cons.
On the ultra-conservative end, it’s not very realistic to expect everyone to cashflow major life expenses like education and housing.
It could take years to accumulate the funds for endeavors like these which could severely limit one’s quality of life.
On the other hand, if you’re too eager to utilize debt for life’s expenses, even a short-lived disruption to cash flow could push you over the edge of bankruptcy and financial ruin.
The best metaphor I’ve heard for debt came from Brian Preston of Abound Wealth in Nashville, TN.
He compares debt to a chainsaw.
You don’t need an exceptional imagination to see how effective and useful a chainsaw can be when used properly. It can make quick work of a large tree.
However, if used incorrectly, the consequences can be gruesome and fatal.
Without going any further into this graphic example, I’ll summarize by assuming you agree that debt should be handled with care.
Debt Categories & Types
There are several ways to categorize consumer debt. Let’s walk through a few here so we can understand them a bit better.
Secured/Unsecured
Secured debt is a loan that is made with some form of collateral as security for the lender. This collateral serves as a way for the lender to reduce the risk that the loan won’t be repaid. That’s because they can repossess the asset and sell it to recover the outstanding balance.
A car loan is a great example.
If the borrower fails to complete payments the lender can repossess the car and sell it to someone else to recover the cash they loaned in the original transaction.
One key benefit of secured debt is the lower risk carried by the lender typically means they will charge lower interest rates on the loan.
Borrowers are also more likely to be qualified for secured loans than forms of debt that do not come with collateral.
Unsecured debt is a loan that does not come with any collateral. As a result, the lender is carrying a higher degree of risk than with secured debt.
Examples of unsecured debt include credit cards, student loans, or personal loans.
Typically, these kinds of loans will require a stronger credit score for borrowers to be approved. Unsecured loans will also generally have higher interest rates than secured debt.
Revolving Debt
Revolving debt is a type of open-ended loan meaning you can draw against the loan or pay it down as long as you’re meeting the terms of the loan and remain in good standing with the lender.
The lender will establish a maximum amount for the line of credit. The minimum payment amounts will vary based on the outstanding amount of debt.
Any unpaid balances at the end of each period will incur interest until they are paid off completely.
The home equity line of credit or HELOC is the most common example of a revolving loan.
Mortgages
Mortgages or Installment debt is a loan that is paid back over a set period of time. Unlike revolving debt, installment debt has a fixed end date.
Payments on installment loans are typically made at the same monthly amount for a defined period of years.
In the case of mortgages, most loans run for a period of 15 or 30 years.
Appreciating Assets vs Depreciating Assets
Another important concept to understand when evaluating debt is the difference between appreciating and depreciating assets.
Appreciating assets are things that tend to increase or ‘appreciate’ in value over time.
Homes are the most common example of this. Although real estate does see occasional dips in market value, overall, the trend is for home prices to increase over time.
Depreciating assets are things that decrease in value over time. Where loans are concerned, automobiles are the most common example of a depreciating asset.
The reason this is important is so you can better understand the level of risk you are assuming when you accept debt against a depreciating asset.
If you borrow all or nearly all of the asset’s value, then you’ll probably owe more than the asset is worth shortly after taking possession of it.
For example, let’s assume you’re buying a new car. You paid $32,000 for it and after one year decide it’s time to sell it.
After looking up its value online you discover the car is now worth $25,000, resulting in a net reduction in value of $7,000.
When you purchased the vehicle, you borrowed all $32,000 of the purchase price. Over the last year, you’ve made all your payments, but you still owe $29,000 on the car.
This means $4,000 has to be repaid in addition to the car’s present value in order for the debt to be settled.
How did this happen? First, your new car depreciated in value rapidly after you acquired it. According to lendingtree.com, new cars depreciate up to 20% in their first year.
Second, the bulk of your monthly loan payments went toward servicing the hefty interest costs that exist when a loan is new. Over time the amount of your payment going to the principal would increase, but you’ve only had the loan for one year.
As a result, you’re what’s known as “upside down” on this loan. This means the asset is worth less than the outstanding loan balance.
This is not a good place to be and can be a tough lesson to learn early in your financial journey.
Be sure you consider how time affects the value of the asset you are borrowing to purchase.
Good Debt vs Toxic Debt
So, when is debt a useful tool and when is it a counterproductive burden?
The short answer…it depends.
There are so many variables: the interest rates of the debt, loan terms, the relative value of the asset over time, the realized utility of the asset purchased, the opportunity costs of funds used to cover interest OR used in lieu of paying cash, market forces on the asset, one’s income to service the debt, and on and on and on.
It should be easy to see that no one really knows what the most efficient choices are when it comes to debt because no one can see into the future with absolute clarity.
We do, however, have enough history with debt to make some predictions about outcomes and make an informed choice.
Generally, I would use the going 30-year traditional mortgage rates as a benchmark when determining whether or not a debt is “toxic” or counterproductive.
This means you’ll probably do better with credit cards, car loans, and many student loans out of your life as a part of Milestone 3.
Another possible way to classify “high-interest” vs “low-interest” debt is to base it on your age.
For someone in their 20s, I’d set the line at 6% interest. Anything above this could be considered “high-interest” and anything below would be considered “low-interest”.
For the 30s, I’d set the baseline at 5% and for the 40s at 4%.
The reason the rate decreases is you have less and less time to save for retirement the older you get.
The abundance of time makes putting away even small dollar amounts worthwhile in your 20s, but that becomes less attractive as you age. Thus, the scale moves with time.
Any debt over the age of 50 should be paid off regardless of the interest rate. Not because you can’t afford it, but because you need to get into a place where you’re not realizing income for the sake of paying off debts. We cover this in more detail in Milestone 8.
On the other hand, if interest rates climb for all debts, it’s possible that any type could reach a point at which it does more harm than good. As with most things, you’ll need to use your noodle a bit to decide what’s best for you.
What I’m presenting below are several common forms of debt, my viewpoint on whether it’s good or bad, and why.
Credit Cards
Credit cards can be a very useful resource for your financial toolbox. For one, they can help you build credit which is especially valuable as you’re just starting out.
Many credit cards also come with rewards systems that may provide a rebate for purchases in the form of cashback, airline miles, hotel points, or some similar benefit.
Select a card or combination of cards whose rewards align well with your particular spending habits or needs.
Another key advantage of credit cards is security. If your debit card or checking information is stolen, any lost funds would be unavailable to you until they’re recovered, if they are ever returned at all. This is one of the primary reasons you should use a credit card for online purchases.
Even with these benefits, we only recommend using credit cards if you can pay off the balances every single month.
Carrying a credit card balance is corrosive to your ability to save money and eventually build wealth.
The average credit card interest rate in 2021 was 19.13% compared to an average of 2.65% for mortgages in that same year. Carrying a balance gets expensive very quickly.
Auto Loans
Albeit a bit unusual, we don’t recommend borrowing money to buy a car. If there’s any possible way to procure transportation without incurring debt, we’d prefer it.
There are several reasons.
First, we covered our example about depreciating assets and how an auto loan can quickly turn upside down leaving you in a tough spot financially.
I should add, that your insurance company will likely only compensate you for the current value of your car if it is totaled in an accident.
Even if you plan to keep the car for a long time, you run the risk of an accident forcing you to pay the difference between the remaining debt and the car’s actual value.
Second, the primary purpose of your automobile is to get you from point A to point B. Our goal should be to purchase the least costly, most reasonably safe option for doing just that.
Instead, culturally, Americans tend to be distracted by the car’s appearance, “cool factor”, power, color, interior, and other features.
As a result, we tend to justify loans to buy status symbols instead of using cash to find a good return in dollars/mile on our investment.
Next, we can be a little lazy negotiating when all the dealer extras can just be wrapped up neatly in the loan.
You just don’t feel the same amount of pain as you might if you were handing over cash for your purchase. In the end, you may end up paying more for your car just because you weren’t motivated to fight for a deal.
Finally, the opportunity cost of the dollars being put into a car (again a depreciating asset) isn’t going to investments instead (appreciating assets). It only takes $240/month invested at 9% for 40 years to reach one million dollars.
- In 2020 the average monthly payment for a used car was $396. Over 40 years, that could be worth $1,853,802.83!
- In 2020 the average monthly payment for a new car was $568. Over 40 years, that could be worth $ 2,658,989.91!!
If you really have no other choice but to borrow money for a car, we use the following guidelines to help make it as painless for your long-term financial health as possible.
- Don’t buy a new car. By a reasonably priced used car that’s already taken the appreciation hit.
- Don’t borrow the whole balance. Put at least 20% down or more if you possibly can.
- Don’t carry a loan period of over three years. You want to be out from under this thing ASAP.
- Don’t buy so an expensive car that you can’t afford to contribute to retirement savings (401k’s, IRA’s, etc.) while you’re paying off your balance.
Student Loans
Overall, we don’t think student loans are all bad. In our opinion, there isn’t a better place to invest a dollar than in yourself and the development of your own skills and knowledge.
According to a recent USA Today article, the average college student will graduate with $32,371 in student loan debt and an average first job salary of $55,260. This is actually a relatively manageable ratio.
However, not all student loans have equal characteristics. Some students graduate with debts well into the six-figure range and in many cases, these same students are making average or below-average salaries.
The result is a years-long struggle to pay down student loans in years that should be used to invest in assets that can compound over time.
As a rule, we’d try to keep those student loans below what you expect your annual salary to be coming out of college.
For example, if you plan to major in geology, a quick web search shows you should expect an annual income of $61,710. So, I’d try to keep my total cumulative loans below this amount.
Once you’ve completed school, we’d recommend some combination of consolidating, refinancing, or locking in your loan amount. That should make the loans a little easier to keep organized and pay back.
Student loan debt can also potentially be classified as a low-interest loan. In this case, it might be better to hold off on paying down the balance and moving on to other debts or the next Milestone.
If you decide the interest rate is low enough to be tolerable, you’d start paying off this debt again at Milestone 8.
Mortgages
As we pointed out earlier, a mortgage is a secured loan against an appreciating asset. This alone makes it one of the least risky types of debt there is.
Add to that the low-interest rates traditional mortgages tend to carry, and you have one of the most logical debt options available to consumers.
Homeownership can also greatly improve one’s standard of living. The feeling of security, peace of mind, and stability home ownership provides are all great advantages.
Finally, home ownership is an excellent wealth-building tool, accounting for 25 percent of the average American’s net worth.
Housing expenses are a fact of life. You might as well direct those costs into an asset you’re gradually becoming the owner of.
Even though we’ve painted a bit of a rosy picture of mortgages, they can still get you into a world of hurt if you’re not careful.
We’d aim to put 20% down and keep the monthly payment below 25% of your monthly income. We know 20% is a tougher and tougher standard to meet, but do try if you can to avoid high-interest PMI (private mortgage insurance).
Also, be sure to think ahead about possible income changes in the future. When we had our first child we decided that she would stay at home for a while.
Fortunately for us, interest rates had decreased quite a bit so we were able to refinance to a lower rate and payment. This was helpful since we went from two incomes to one.
If rates increase or stay the same you may not have this option.
Even if you choose not to pay off your mortgage at this point, consider the interest rate on your loan versus the current rates for a similar loan. Refinancing may pay for itself in the form of reduced interest and a lower monthly payment.
Methods for Paying Off Debt
Set a Budget
You’ll probably get nowhere fast without a budget and even if you do make progress paying down debt you can probably accelerate it by reviewing your expenses. See our previous post about budgeting here for more information.
Have some cash on hand
You also shouldn’t dedicate EVERY dollar to debt reduction. Keep a small “Uh-oh” fund of at least $1,000 so you can handle unexpected expenses like car or home repairs without accumulating even more debt. We covered the “Uh-oh” fund in this post.
Debt Snowball
The debt snowball method calls for borrowers to pay minimum monthly balances on each debt before directing any remaining funds to debts from the smallest to the largest outstanding amount, regardless of the interest rate.
While not the most efficient approach monetarily, this is the fastest path to chalking up a mental victory on your debt reduction journey.
If you feel that you would benefit from the psychological boost of a quick score in the win column, this may be the route for you.
For example, let’s assume Danny Debtor has the following debts:
- $30,000 student loan at 5% with a monthly minimum payment of $200
- $10,500 car loan at 6% with a minimum monthly payment of $250
- $15,000 credit card debt at 15% with a minimum monthly payment of $150
After creating a robust budget and paying all necessities and minimum required payments to his debts, Danny has $1,500 per month to direct toward paying off his debts early.
Using the snowball method, Danny would begin by making the minimum monthly payments on the student loan ($200) and credit card ($150) before directing the remaining $1,500 toward his car loan.
After 7 months Danny would have eliminated his car loan, incurred a total of $210 in interest on the loan, and begun working toward paying off his credit card debt.
With the car loan out of the way, Danny now has an additional $250/month to direct toward his next debt: credit cards.
At $1,750 each month, Danny will have his credit cards gone in a little over 8 months and incur $1,895.63 in interest. Now Danny has another $150/month to attack the student loans.
At $1,900 per month, it would take Danny 15 months to pay off the student loans. However, by paying the monthly minimum for the previous 15 months as he was focused on the car loan and credit cards, Danny now owes $27,000.
As a result, he pays off his last debt a little over thirteen months later and incurs $2,672.08 in interest while paying down the debt.
All told, using the debt snowball method Danny paid off his debts in about 28.5 months and incurred interest expenses of $4,777.71 during the paydown period.
Debt Avalanche
On the other hand, if you want to pay your debts in the most cost-effective manner possible, the debt avalanche is the way to go.
The debt avalanche method means you’ll contribute the minimum payments on each debt, then contribute the remainder to your highest interest debt, regardless of the amount, before moving to the 2nd highest rate, and so on.
As a result, each dollar you contribute to debt paydown has the biggest possible impact.
Remember, if your highest interest debt also happens to have the highest interest rate it may take some time to completely eliminate your first debt and get that mental boost.
Let’s see what happens if Danny Debtor uses the debt avalanche. Remember Danny has the following debts:
- $30,000 student loan at 5% with a monthly minimum payment of $200
- $10,500 car loan at 6% with a minimum monthly payment of $250
- $15,000 credit card debt at 15% with a minimum monthly payment of $150
This time Danny starts with the credit cards since their interest rate is the highest. It takes him 10 months to eliminate the debt and he incurs $1,031.25 in interest while paying it off.
Moving on to the car loan, Danny pays it off 4 months later and incurs interest charges of $551.25.
Finally, Danny pays off the student loans after an additional 15.5 months and incurs interest expenses of $2,678.33.
All told, Danny pays off the same debts in 29.5 months at a total interest cost of $4,260.83.
So, by using the debt avalanche Danny took roughly an extra month to pay off the debt, but it saved him a total of $516.88 in interest over the paydown period.
This was a simple example. The interest costs and pay-down periods could vary greatly depending on your situation, but hopefully, this gives you some idea of how these methods work.
Conclusion:
Paying off debts is probably the toughest lift on the entire Next Dollar Roadmap. It’s just no fun throwing your available cash into something that you don’t see a regular tangible benefit from.
Depending on your past, this milestone can also take quite a bit of time to complete.
However, the feeling when you finish will be totally worth it. Having more disposable income that you can begin to put to work on your behalf is incredibly refreshing and the journey only improves from there.
Next stop, Milestone 4: Fully Funded Emergency Fund
