By: Molly M Grubb, AIF®
Part of financial independence is getting rid of bad debt. What is bad debt? It is a personal loan that has a high interest rate and greatly affects your monthly cash flow, and it tends to be a loan for a depreciating asset (an asset that declines in value over time). Here are some steps to increase your cash flow by getting rid of bad debt.
- Create a Summary Sheet: Create a sheet of all the terms of your outstanding debt, including credit cards, school loans, mortgage, and any other forms of debt. This needs to include the date of inception of the loan (if it is a fixed loan like a car loan and not a revolving loan like a credit card), the date the loan will expire (again, only if it is a fixed loan), interest rate, original loan balance, current balance, and monthly payment. There are a lot of wonderful tools to organize the summary sheet, but for a simple and free metric to record, use an Excel spreadsheet.
- Prioritize: Okay…now that you are organized, you want to single out the top three loans in the following categories: highest monthly payment, highest interest rate, and shortest payoff period (there may be one debt that is the top two or three for these categories).
- Create a Strategic Plan: Fantastic! You are now strategically looking at how to become financially free of debt! Let’s start designing a plan by organizing the top three debt obligations (keep in mind this may only be one or two loans from step 2). Organize the debts to pay by a) shortest payoff period, b) highest interest rate, and c) highest monthly payment. Use your discretion when prioritizing, based on how short the payoff period may be or how high the interest rate is.
- Execute: Now that you have prioritized the order in which you are going to pay off the debt, it’s time to execute on it. Focus on any extra dollars you can allocate toward the top priority loan, then keep your total payments allotted toward debt payments the same; even as loans are paid off, keep making the same payment toward the next loan. For example, if you are paying $600 on loan one and $200 on loan two, keep making an $800 payment on loan two after loan one is paid off. Once all debt is paid off, keep making the same payment, but make it to the most important debt collector…yourself.
There are several tricks that you can use once you begin to pay yourself first by becoming the bank and paying yourself interest when you need to borrow money. Use these tricks when borrowing from your 401(k), on your life insurance, or from a family bank and if you own your own business.
Grubb Wealth tidbit: If you are thinking about getting a mortgage, you can take out a 30-year mortgage (with, let’s say, $1,000 monthly payments) but pay on it according to a 10-year amortization schedule (let’s say a $1,500 monthly payment). However, instead of paying the bank the full 10-year amortization schedule payment of $1,500, you continue to pay the bank $1,000 and pay yourself $500 a month, ideally into an investment account that grows at a better interest rate than you are paying the bank. Over the next seven to nine years, your savings should equate to what is needed to pay off your mortgage. However, rather than putting yourself in the bondage of a higher monthly payment, you now have a savings account in case you lose a job or have a major health issue. By doing this, you can ensure that you will still make your mortgage payment and not risk losing your home because you chose a higher monthly payment.
Be diligent about the process of paying off your debt. Continually monitor and strategize as your finances and life change. These four steps are not something you do once; they are a process that you implement to gain and keep financial independence.
This blog is a publication of Grubb Wealth Management. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of any subjects discussed. A professional advisor should be consulted before any investment decisions are made. All expressions of opinion reflect the judgment of the author on the date of post and are subject to change.