In this context I am talking about “bad” debt or non tax deductible consumer debt, that is debt for consumable items which decrease in value and do not bring you an income. “Good” debt is another matter, because this is usually tax deductible debt. Of course you will eventually want to pay off all your debts, good as well as bad. True wealth comes from your net worth and the assets you own that bring you an income. True financial independence comes from making enough money from your assets to exceed your expenses. Remember, DEBT IS NOT WEALTH. Debt is usually a claim on tomorrow’s income for today’s consumption. Debt is debt, a liability and obligation on your future earnings, and will have to be repaid sometime.
Firstly, work out what extra money you can put aside to add to your debt repayments (bearing in mind that you should also be putting some money away into your savings). Any amount extra you can add to your repayments will help reduce the debt so much quicker. In another post we will look at other income streams or where to get extra cash from.
Next, compile a list of all the debts you have. Mortgage, car loans, credit card debt, store card debt, loans from friends and family, HECS fees or school debt, everything and anything that you owe basically.
Write them on a piece of paper down the page or put them into a spread sheet. Firstly, write down what it is, eg. home loan, ANZ credit card, Westpac car loan etc., then list the balance owed (this is what’s left to repay, not the initial loan amount, so unless you haven’t made any payments yet, this should be less than the value of the total loan), the minimum monthly payment and you can also put in the interest rate for your information. You should have four columns.
You will need a fifth column. This is to calculate your debt ratio for each loan and work out your order of repayment.
Firstly divide your monthly payment into your debt balance. This should give you a number. So for example, if you have a $2,000 loan, and your monthly repayments are $100, the debt ratio is 20.
$2000 / $100 = 20
Do this for all your loan to give you your debt ratio number for each loan.
Now rewrite your list or rearrange your spread sheet in order of the loan with the lowest debt ratio to the highest debt ratio. This is the order in which the debts will be repaid. What’s important to note here is that the earlier debts to pay off are not necessarily the debts with the highest interest rates. The ratio lists the debts in the order that have the most impact on your cash flow.
Go to the first debt on the list, and add the extra money you can spare to pay off your debts into this debt, while still making the minimum monthly repayments on all the other debts. Keep paying off the debt that is number one on your list, with the extra payment included until this one is paid off.
Now, if this is a credit card or store card debt, this does NOT mean that you now have this available to spend again. Remember the goal here, which is to reduce all your debts.
Get into the habit of paying cash or saving for what you want. If you don’t want to carry cash, then put it on your card, but make sure it is paid off in full by the due date. Better still, set this up automatically so that your card is paid in full on the due date by a direct debit.
OK, you’ve paid off your first debt on your list. This money is not available for you to spend yet. We’re on the path to financial independence remember, so we will have some short term pain for long term gain.
The entire amount that was used to pay down the first item is now available to be put into the second debt on your debt ratio list AS WELL AS the minimum monthly payment for this debt.
When the second item on the list has been repaid, once again, this entire amount is now used to pay off the third item on the list.
So now the repayment amount is the minimum monthly payment for this debt, the minimum monthly payment for the previous debt(s) plus the extra amount you were able to put aside in a bid to actively reduce your debt.
You will find your repayment time drastically reduced because of the extra payments,. Or you might even find that a debt which a bit further down the list, which you haven’t gotten to yet, actually gets paid out before you have a chance to apply the extra payment to it, because you are still making the minimum monthly repayments into this debt. If this happens, add this minimum payment to your other debts.
Because you were already making minimum monthly payments to the other loans and just a little bit extra into the current loan, you’ll find you don’t even miss the amounts you are directing into the next debt on your ratio list, as you were making this payment anyway. And now it’s being put to a good purpose in reducing the amount of “dead money” interest you are paying.
Keep doing this until all your debts are repaid. Now, and this is very important, DON’T GET INTO FURTHER DEBT. Well, not for non deductable consumable items anyway. Since you didn’t miss the money when it was being used for debt reduction, you could now redirect this free money into your savings, either your investment account or saving for items you want. Or better still, split it so it goes to both areas. There’s no reason you can’t reward yourself for your discipline.
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