Credit is an awesome thing. You can take something home or have an experience without even paying for it! Yet. Because you will pay eventually. And when you do, it can be surprising how much it costs. But we’re not taught that part up front.
I’d love to say I knew exactly how credit cards worked when I got my first card in college. I remember being really excited. I also remember not having a clue. Because no one ever taught me this stuff. They rarely teach it in schools and the few times they do, we’re 16 and think we know everything so we hardly pay attention. (Oh come on, admit it, I know I wasn’t the only teenager who thought that.) You take out a college loan because that’s what you’re supposed to do and besides, everyone else does it too. You use loans to buy a car because how else will you do it? And then suddenly you have piles of debt.
You want to get rid of it, but it feels insurmountable. You’ve been told it will hold you back, but you can’t see how it really matters. It doesn’t seem to affect your life, but it’s niggling at the back of your mind. Sound familiar?
So let’s talk about debt, how it works, and what to do about it.
The messages we hear
“Debt is no big deal.” “Debt is the devil!” “Everyone has debt.” “No one should ever have debt.” “It’s not like you can avoid debt.” “It’s so easy to avoid debt.”
I hear these things all the time. Everyone has different opinions on debt and I think that’s great. It’s good to have opinions.
The problem is that news articles talk about debt being bad, but not why or how. Ads point out the benefits of credit cards and loans, but not the downsides. Credit is handed out and accepted like ice water on a hot day. There’s a lot of talk, but not a lot of information.
Then there’s the talk about “good debt.” Personally, I don’t think there’s any such thing. Yes, making regular payments on your debt can raise your credit score. But you can also have a high credit score without having any debt at all. My friend Jane never had any debt in her life and her score is in the mid 700s.
The only debt I can ever imagine having is a mortgage, and that’s because buying a house without a mortgage is impossible for most people. But that’s it. And that debt still isn’t good! (Some people get stuck with medical debt and that is a failing of our healthcare system. It should never happen, but it does all too often. The best you can do is pay it off as soon as you’re able to. I’ll get to that in a minute.)
I believe any other debt is bad.
A car loan is unnecessary.
Credit card debt is evil and will weigh you down.
And school loans should be avoided as much as possible, though I recognize that won’t always be an option. If you want to be a doctor, for example, you have to go to medical school and you probably won’t have the cash for that up front. But you’ll be working in a high paying job so you can pay it off soon after you graduate. I can understand school loans that lead to degrees that in turn lead to well paying jobs. I can not get behind school loans for degrees that won’t pay well. I’ve learned a lot since I got my degree in Spanish. (Yeah, I did the liberal arts thing.) Unfortunately, few people make that distinction during their senior year of high school when they apply for loans.
Now, I hear what you’re saying. If you want to get a degree in some liberal arts field that won’t pay well, you should be able to do that. I get it. The thing is, you’ll be chaining yourself to that debt for the next 30 years, so you better be very sure that’s what you want. If you’re ok with it, that’s fine, but make sure you fully understand it. Everyone else does it, but that doesn’t mean it’s the best approach. My big problem with debt isn’t simply that people have it, but that they take it on without understanding what will happen. It’s hard to explain this, so let me show you.
And don’t worry, if you already have debt, I’ll show you what to do about that, too.
What you’re really paying for those llamas
Ok, I admit that I have no clue if you can buy llamas with credit cards. I’m using llamas as an example because they’re more interesting than most things I can come up with, and because I was reading a book about crochet today that just made a funny joke about llamas and alpacas. Plus, look how cute they are! And you just can’t argue with that kind of logic.
So let’s say you decide to buy $1000 worth of llamas. (Or a new iphone with accessories. Or a plane ticket.) You don’t have the cash, so you put it on your credit card. How much will the llamas cost you in the end?
Aside from their food and shelter, of course.
Well, that really depends on when you pay off the credit card. Let’s check out a few possibilities. We’ll assume the interest rate on the card is 18.99%. Some are more, some are less. This is a good middle ground. And we’ll also assume you don’t put any other purchases on this card until the llamas (iphone, plane ticket, whatever) are paid off, because it just makes things simpler to follow.
Option 1: Pay it all when the bill is due
If the bill comes and you pay the full $1000, then the cost to you is $1000. Now you just need to ask yourself why the hell you spent $1000 on llamas, especially since you live in an apartment. Your roommates aren’t going to like this!
Option 2: Make minimum payments until you get down to $25, then pay it off
You set up your account to automatically withdraw minimum payments from your bank each month. Then you forget about it. Eventually you check in, and when you see the balance at $25.01, you just pay the darn thing off already.
Because at this point it’s been 30 years and 8 months since you bought the llamas. The llamas died, and you were still paying for them! If you used that $1000 to buy an iphone, you’ve gone through about 15 phones by now, and you’ve moved on to 3D holograms and teleportation, but you’re still paying for your old 2016 iPhone6 and accessories. You’ve now paid $1542.92 in interest. That’s in addition to your original $1000 charge. That means you’ve paid a total of $2542.92 for $1000 worth of llamas!
$1000 was a great deal for those llamas, but would you have knowingly paid $2542.92? Would you have paid $2542.92 for the iphone or for the plane ticket?
Option 3: Make minimum payments plus an extra $25 every month
You did the math and you decided that minimum payments weren’t the best way to go. Instead, you figured you’d throw some extra money at the llamas every month. You decide you can pay an extra $25 and still have enough left over to keep the llamas happily gorging on hay.
Your first month’s payment is $50.83 (the minimum balance of $25.83 + $25 = $50.83.) You set up the automatic payments and forget about it.
2 years and 10 months later you make the final payment of $12.06. The llamas are a bit older, but they’re doing fine, munching on hay and doing whatever else it is that llamas do (hey, I’m a city girl, I’m just getting my information from Google.)
You end up paying $258.05 in interest. When you add back in your original $1000, the llamas cost you $1258.05! That’s a whole lot less than Option 2, but still a lot more than you’d planned to spend. Would you have still bought the llamas (or phone or plane ticket) if you’d known you were really spending $1258.05?
If you’d like to play around with your own numbers, keep reading and I’ll give you the tool to do it automatically.
Here’s the point, and what you should do instead
Whether your debt is currently $50 or $500,000, the important thing is to understand the role that interest plays in it and to know how much you’re actually paying in the end.
Sometimes debt is your only option, but usually it isn’t. In most cases, if you can’t afford to pay cash for something, you can simply not pay for it. Maybe you could put off buying the llamas for a few months, until you can earn some extra money to pay for them up front. Maybe you can use your phone for another 6 months because it’s really doing decently. Or you could buy a used one for cash, instead. That vacation can wait until next year. Or you could go camping locally instead. Or cash in some frequent flyer miles. Do whatever you need to do so that you don’t have any debt!
And when you are considering taking on debt, look at the real cost of what you’re going to buy. Are you paying $1000 for those llamas, or $1500? Are you paying $500 for that laptop, or $800? Are you spending $2000 on that cruise or $4000? Then ask yourself, is it really worth it?
Because you might love how your ass looks in those $50 jeans, but be honest: would you think it looked as good if you were going to end up spending $125? Maybe not.
The role of monthly payments on your monthly budget
There’s another reason why debt is a problem, and this is too often overlooked. While you’re paying down your llama charge every month, what are you not spending your money on?
Because your income is finite. That means that unless you’re taking on more debt every month (and if you are, see “What to do about it”, below) then your spending is finite. What aren’t you paying for?
If you hate living paycheck-to-paycheck and you’re paying $150 towards your credit card bill every month, imagine how fast you could built up some savings if that $150 went into the bank instead (hint: $1800 per year.)
If you wish you had more money to spend on vacations and you’re paying $220 every month towards your car loan, imagine how fast you could build up that vacation fund if you could put $220 towards it every month (hint: $2640 per year.)
If you worry that you’re not saving enough for retirement and you’re paying $500 towards your student loans every month, imagine how much you could be putting towards your 401k if not for the loans (hint: $6000 per year, plus whatever tax breaks you’d get.)
And if you’re paying for all 3, you just got a sinking feeling when you realized that adds up to $870 per month, which is $10,440 per year.
What to do about it
I bet reading that sucked. Big time. So let’s do something about it!
Because you can do something about it. I’m not saying you’ll have your debt paid off tomorrow, next month, or even next year (depending on the size of it and your income) but I can promise you this: if you don’t make a plan to get rid of your debt, it will continue to haunt you.
Now, as I always say, there are 3 ways to increase your savings: earn more, spend less, or do both. The same is true for paying off debt. I recommend doing all three. But first you need to do something else.
The absolutely positively MOST important step to paying off debt
The first thing you must do is stop making more debt. This might not happen overnight. If you’re used to spending money on credit cards that you can’t pay off right away, you’ll need to change that habit first. Take those credit cards out of your wallet. Remove them from your online shopping accounts. Hide them away for emergencies and only use cash from now on (a debit card works, too.) That way you can’t overspend.
Next, commit to making destroying your debt your new #1 priority. You WILL destroy this debt!
If you have one debt
Decide right now how much money you are going to put towards your debt every month. This needs to be well above the minimum payments. Use this calculator (just enter your email address and I’ll send it to you) to figure out how different payment amounts will affect when the debt will finally be gone and how much you will have paid in total.
Start small if you need to. $5 or $10 per month is a great start. Then plan to increase it as much as you possibly can. After you reach that amount, do even just a bit more than that.
Check out how to cut back on overspending and how to save more each week for some ideas. There are countless ways to earn extra income. Look at your calendar. Find some time to sell unneeded items from around the house. Do some dog walking. Call your cable company and temporarily stop service. Cut back on all expenses asap. The only way you’ll get rid of your debt is to throw as much money at it as you can. Remember, you’re doing this so you can gain freedom. Once the debt is paid off you can resume reasonable spending, but right now, it’s all hands on deck: the debt must be destroyed!
Are you questioning if it’s worth that much effort? Check out “What happens next” below.
If you have multiple debts
Like with paying off one debt, first you need to figure out how much you will put towards paying off your debts every month. Follow the links above for ideas to earn more and spend less. Then, make a plan for how to address each debt.
Having multiple debts can be overwhelming. You might have 9 different college loans, 2 credit cards with balances, and a car loan. Where do you begin?
Most people are tempted to take any extra money they have each month and put a little towards each debt. The problem is, by putting just a little towards each debt, the extra money gets eaten up by interest and it feels like you’re just not making any progress.
Others prefer to put all extra money towards the debt with the highest interest rate. This makes a lot of sense logically. The problem is that if this particular debt has a large balance, it can take a long time to notice any progress and that can be discouraging. It doesn’t matter how logical a plan is; if you quit, then it’s no good.
That’s why I’m a big fan of the snowball method. A friend spent years trying to pay off debts using the two methods above and kept getting discouraged and giving up. Then he tried the snowball method and suddenly he saw progress! Just a few years later he was debt free!
The snowball method is simple:
- Order your debts by balance, from smallest to largest.
- Make minimum payments on all of your debts.
- Take all extra money you have available each month and put it towards the debt with the smallest balance.
- When the debt with the smallest balance is paid off, take all your extra money each month (which should be more now, because you have the minimum payments from that smallest debt available now that it’s paid off) and put it towards the second smallest debt.
That’s it! Here, let me show you how this works:
The advantage to this method is that you’ll quickly see progress as one debt after another gets paid off, and that will encourage you to continue. And remember, the more money you can put towards your debts, the faster you’ll pay them off.
What happens next
As you pay off each of your debts, you’ll begin to feel lighter, freer. Soon you’ll be excited to make even more progress, and you’ll probably surprise yourself by finding ways to earn a bit of extra cash or cutting back on expenses that you thought were untouchable because you want to see that debt disappear asap.
Once the debt is gone, you’ll have many possibilities before you. All of that money you were throwing at your debt every month will now be available for other things. You might choose to cut back on your income-earning activities. You might decide to resume some of the spending that you’d cut back on. But now that you have a taste of the debt-free life, you’ll be committed to making sure you never go back to the days of debt again.
You’ll beef up your emergency fund first. Then you’ll increase your retirement savings. You’ll put some money towards big future expenses: a car, travel, a wedding, buying more llamas, a house. Now that you have hundreds of dollars available every month, you’ll be able to save for these things.
You won’t worry when the bills come. You’ll pay every one on time and in full – no more debt for you!
Does this all sound lovely? This is what you’re working towards. If you feel frustrated at any point, just return to this lovely image. It’s yours for the taking! I have no doubt you can do it. The key is to go all in. A half-assed approach won’t work. But treat your debt as your #1 priority and you’ll be amazed at the great progress you make towards kicking its butt out the door!
The choice is yours
You now have the tools you need to move forward and pay off that debt. Go for it! You never again have to pay $2500 for $1000 of llamas. So what will you do? That’s what I thought! Congratulations on taking the first steps to the new debt-free life you deserve!
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