It’s never too early to clear your debts
There are a lot of people that need help clearing debts, and they need to get out of debt fast. While there are obviously a myriad of clear debt solutions, there is always the best way to clear debt. In this section, we will walk you through the process to get you debt clear via debt elimination steps.
Until you get full control of your finances and channel all your income into wealth building, you are not likely to build and keep your wealth. That is why clearing up your debts is the most important step right after your emergency fund building. Debts are the number one factor that slows down your wealth building process.
Imagine swimming in a pool of clear water vs. swimming in a pool full of mud. With the same amount of energy, you are guaranteed to move much faster in clear water than in the mud, if you will move forward at all.
The same principle applies to wealth building. Debts are just like mud. The interests you pay to your debtors, when compounded, slow you down and drown you in your wealth building journey.
That is the reason why so many people cannot break out of the vicious cycle of debts. They are channeling their resources into clearing up debts, but without a systematic method, the debts just seem to pile up and snowball along the way.
The bottom line is, it is easy to become wealthy if you don’t have any debts to pay off. Imagine not having to pay your students loans, car loans, medical debts, and even your mortgage eventually. All your income can be channeled into wealth building instruments, which is where your money should really be. Not in debt interests.
Identify the Enemy
A typical American with $50,000 annual income would have the following monthly payments to make:
- $850 house payment
- $495 car payment
- $165 student loan payment
- $450 credit card debt payment
- $120 miscellaneous debts (personal loans, furniture, gadgets)
Total: $2,080 per month just in debts payment.
Now, imagine if we are to channel this amount instead to a low-cost index fund yielding an average of 8% a year (average annualized return of index fund from history), we will have $500,000 in just 13 years, and $1,000,000 in 18 years. That’s a million dollars in 18 years time. It may not sound impressive to some of you, but let’s carry on.
This $1,000,000 will grow into $1,500,000 in another 4 years time, and $2,000,000 in another 3 years time, and $2,500,000 in yet another 2.5 years time. As you can see, the time to grow your investment decreases exponentially as your investment gets bigger, such is the power of compounding.
|Investment Value||Years Needed|
Power of compounding — Time required to grow your investment decreases exponentially as your investment grows larger
We will talk more about this in Step 6, the final step that will eventually lead to your financial freedom — a self-sufficient system that provides you income indefinitely, freeing you from the shackles of rat race.
Why Don’t I Start Investing Right Away?
At this point you would probably be thinking — if the power of compounding is that great, shouldn’t we get to investing right away? Wrong. You see, as much as the power of compounding can do wonders for you, it can work against you in even more horrendous ways. Read on.
Did you know that the average credit card annual interest rate (APR) is 18%? According to CARD act, companies can raise your APR up to 29.99% if you are 30 days late on your payment. Let’s work out the math:
Suppose you have a credit card debt of $10,000, and you make minimum payments every month without fail. We assume further that your credit card APR is 18% (average rate) and the minimum payment is $300 per month, you will take a staggering 245 months to pay off your debt, if you don’t pile up new debts. That’s 10 years time of paying debt!
But you may ask — if I pay $300 per month, which equals to $2600 a year, I would imagine clearing up the debt in just 4 years time. But in fact, in that 10 years time, you would have paid $9,698.17 in interest. That’s the power of compounding working against you. Even if you are clearing your debt bit by bit, a big chunk of your monthly payment goes to the compounding interest.
Effectively, you are paying $19,698.17 for using $10,000.00.
I hope by now you have realized the importance of paying off your debts as quickly as you can. By paying off credit card debts, you are essentially investing your money at 18% annualized return. There is simply no better way to invest your money than to clear your consumer debts first.
Clear Debt Fast, Including Big Debts
There are actually shortcuts to clear your card debts much faster, even if you do not have additional monthly income. It’s called debt consolidation. Basically you borrow a loan at a lower interest rate (APR) than your current credit card APR, and use the borrowed amount to clear debt directly. Then you focus on paying off just one personal loan at a low interest rate. Essentially, you get lower interest loans to clear debt.
The APR of your personal loan depends a lot on your credit score, just like your credit card APR. Your credit score is a 3-digits number derived from your credit report and is one factor used by lenders to judge your creditworthiness for a loan or a credit card. The higher the score, the better rate you will get.
If you don’t know what your credit score is, you can get it for free from creditsesame.
Just sign up for a new account and you should be entitled to claim your free credit score. It is always good to know your most current score as all your loan rates will inevitably be determined through your credit score.
Once you have obtained your score, you are ready to request a quote for a personal loan.
You can get good personal loan with fixed interest rate for as low as 6% APR here, depending on your score. After application, you will be given a chance to review the APR of your new loan.
Do compare the APR rate offered to you versus the rate of your current debt, and only take up the loan if the new APR is lower than your current APR.
When you receive the new loan, DO NOT spend it on anything other than your debt. If you have extra money left after clearing your debts, save it up and use it to pay towards your first loan repayment. We have to exercise some self control if we want to achieve financial greatness.
A debt consolidation loan is something you should consider only if you are carrying a balance on your credit cards. If you do not carry any debt, or if your debt is at a very low interest rate, there is simply NO reason to consolidate your debt into a loan.
However, if you are carrying credit card balances at high interest rates, then it makes sense to consolidate as much of your credit card debt as possible into a personal loan. Using this strategy, you can free yourself from the high interest rates, and at the same time reduce your monthly payments to just a single payment on the one personal loan.
Let’s assume we are to consolidate a total of $15,000 credit card debts with 18% APR into a personal loan with 10% APR paid over 3 years:
|Years to pay off||3.5||3|
Pay off your debts much quicker by consolidating your debts into a single, lower interest loan
By consolidating the debts at a lower APR, we save $3575.64 and pay off the debt in just 3 years time with a comparable contribution every month.
This strategy works very well if you have a large consumer debt, generally $3,000 and above. But if your debt is small, you might want to save the hassles and use the method below instead.
Working with Small Debts
List all your debts in order, with the smallest amount or balance first. For now, don’t be concerned with interest rates or terms unless two of your debts have similar balance, then you list the debt with the higher interest rate first.
After you list your debts from the smallest to the the largest, pay the minimum amount to stay current on all the debts except for the smallest one. You want to attack the smallest debt with all you have until it is fully paid off, then cross it off.
Remember the monthly amount that you used to save up your emergency fund? After getting your initial $1,000 saved up, you channel the amount into paying off your debts diligently. Do not spend that amount on luxury items that are not essential. At this point of time your only focus is to pay off your debts. From the smallest to the largest.
You can list down your debts on a piece of paper and paste it on somewhere you can see everyday, like on your fridge. When you pay off a debt, strike it off and focus on the next one. Once you have seen it work, you will keep doing it because you will be fired up about the fact that it works.
If you are still with me up to this point, you are already making great strides in your personal finance. In fact, once you realize that you should be paying off your debts before saving up and investing, you are already on your way to financial freedom. Make sure you complete the to-do list below!
- List all your debts
- Obtain your credit score
- Consolidate your debts if it’s >$3,000
- Pay off from smallest to biggest if it’s <$3,000
This article is one of 6-step series “Achieve financial freedom in 5 years time“.