You can reach financial success but you need to manage your debt wisely.
Be ready to tackle some tough choices and trade-offs if you are aiming to grow and accumulate wealth
Your planning should start as early as possible so that you have a reasonable early start on your roadmap to accumulate wealth, have financial flexibility, and retire comfortably and early. To strengthen your financial health, you need to deal with your debt wisely.
You will accumulate debt in your lifetime.
Borrowing is not always a bad thing especially for good reasons like for your college education, furthering your career or buying your home.
Getting a college education is expensive.
Jumpstart your children’s college education by investing in 529 savings plans for your child’s education as early as possible. This will lessen your debt burden and potentially lessen theirs as well. About one-third of student loan debtors say they were late paying their bill at least once in 2017.
Plan to get the more attractive federal loans. Apply for scholarships, grants and work-study programs. Most importantly, make sure you and your children understand how to repay yours and their obligations on time.
Read our post: “How To Pay For College: A Family Guide.”
Buying A Home
Before actively looking to buy a home, make sure to check your credit reports first to see what kind of financial shape you are in. Make sure it becomes a regular part of your life to habitually check your credit reports and score. It is not uncommon to find errors or issues which can be corrected but it takes time. You should deal with it quickly.
See our post on reviewing your credit reports: “Are You Creditworthy?…”
Consider 15 year fixed mortgages vs. 30 year fixed mortgages
When buying a home, consider opting for a shorter term mortgage as your total cost will be lower.
Let’s use an example to illlustrate what your mortgage costs will be:
Assume you found an $800,000 single family home, putting a 20% down payment, or $160,000. In both mortgages, you are borrowing $640,000. I know what you might thinking..that is an expensive home! Bear with me a bit.
Recent rates from NERDWALLET’s mortgage calculator produce these numbers:
The 15 year mortgage rate is 3.4%, and you will be paying a higher monthly amount (principal and interest) of $4,544 versus the lower monthly amount of $3,092 based on a 30 year 4.1% mortgage interest rate. The higher rate for the longer 30 year period is expected. These rates are pretty attractive.
Here is your breakdown for your 15 year mortgage:
- Monthly principal and interest costs: $4,544 and total year’s costs are $54,528, excluding down payment.
- Your home’s total costs with a 15 year mortgage are $977,898.
- This includes the $160,000 down payment, $640,000 you borrowed and $177, 898 in interest payments over the course of 15 years.
Here is the breakdown for your 30 year mortgage:
- Monthly principal and interest costs of $3,092 and total year’s costs are $37,104, excluding down payment.
- Your home’s total costs with a 30 year mortgage are $1,273,289.
- This includes the same $160,000 on a 20% down payment, $640,000 you borrowed but a whopping $473, 289 in total interest costs based on the15 year longer time frame.
The 30 year mortgage added $295,391 to the price of your home. That amount could be put into investment or retirement accounts, or can be used to pay down your student debt, and provide you with extra financial flexibility!
Existing home prices appreciated annually from 1968 to 2009 by 5.4% from 1968 to 2009 based on the National Association of Realtors but that doesn’t take inflation into consideration which may bring down the rate. Also, prices vary significantly across the country.
While it would be nice to get a price pop on your home, remember you are living in it and hopefully enjoying the house. If you are fortunate to get a low mortgage rate, this is good debt to have.
Look at your borrowing rate versus potentially alternative investment returns if you did not have a mortgage.
The 3.4-4.1% respective mortgage rate above is attractive. It allows you to free up capital you would have used to buy that home and invest it in the higher yielding S& P 500 stock index, which have higher returns than the mortgage rate you would be paying.
Inclusive of dividends, S&P annual returns generated 12.50% post WWII. Longer term, the S& P 500 generated annual returns were over 9%.
You want to make good trade-offs. If you are able to afford the 15 year mortgage monthly amounts, it is a better investment.
You need to shop around for mortgages using calculators are conveniently available online.
Good Debt versus Bad Debt
While using debt for student loans and mortgages can be painful to bear, it is for the good of your future that is likely to result in a good career and higher earnings.
If you can get an affordable mortgage by buying a home you will love, you should realize modest home appreciation, pacing inflation. Your home should allow you to preserve your capital.
You need good financial habits when dealing with credit card debt
Don’t overleverage yourself with credit card debt. Have rules you can keep. Pay off your credit card balances off in full every month.
According to FINRA’s 2015 financial capability study, 32% of consumers pay only the minimum monthly card balance as compared to 52% that pay the balances in full. Paying the roughly 2.5% required minimum on a $3,000 balance can take over 20 years to pay if off.
APR vs APY
A credit card’s interest rate or the annual percentage rate (APR) is your price you pay for borrowing money, and it is usually the highest rate (high teens percentages unless you have great credit) you will pay. Far higher than for mortgages or for student loans. The APR doesn’t include the compound interest rate.
On the other hand, the effective annual rate on the annual percentage yield (APY) does include how often interest is applied to your balance (eg. daily, monthly quarterly or yearly). This means that when you don’t pay your card’s monthly balance in full, you are paying interest on interest. Here, compound interest is working against you, building up your debt amounts.
Remember these credit cards interest rates are higher than mortgage rates.
Depending on your credit score, whether you are an existing card holder or a new card holder your APR could range from 15%-19%. According to Federal Reserve’s report in February 2019, average credit card interest rates were 15.09%, and including assessed interest were 16.91%.
Borrowing rates will likely rise for types of debt as the Federal Reserve hikes the federal funds target rate.
The average US consumer has 3.1 credit cards with an average balance of $6,354 plus an additional 2.5 retail store cards with $1,841 average balance according to Experian’s 2018 study. About 41.2% of all households carry some credit card debt.
If you pay the minimum amount required, there will be no changes on your credit score and no fees but it will take a long time to pay down your debt.
If you miss that monthly minimum, you will pay dearly after 30 days of nonpayment. You will incur a penalty rate upwards of 29.99% monthly until you make six consecutive payments on time. You will also pay flat fees, and your credit score will be impacted negatively.
If you can’t pay your monthly card bill in full each month, cut your spending. When you pay only the minimum balance on your cards, you will be wearing a financial noose around your neck far longer than you want.
Be careful about what you put on your credit card
I have always been fearful of building up my debt levels (not counting our mortgage) so I have often paid cash or by check. It increases your pain of spending much faster and introduced me to financial discipline at an early age. Pay for more things with cash like your next car and make it a used car.
When you shop for credit cards, make sure you read the fine print known as the terms and conditions. You need to understand your effective annual rates, the penalty rates, late fees and such.
When you get overwhelmed with your credit card balance and your debt balances, make reducing your debt levels your top priority. The stress levels of having too much debt can engulf us, resulting in higher absenteeism at work and an inability to fully function.
Related Post: Common Credit Mistakes And How To Avoid Them
Two methods to reduce debt: the Avalanche Method and the Snowball Method
Assuming you have the following debt balances:
- Credit card debt of $3,500 @ 15%
- Student federal loan#1, of $5,000 @ 4.5%
- Student private loan#2, of $7,000 @ 7.5%
- Car loan of $13,000 @ 5%
- Miscellaneous debts of $1,500 @ 4% average rate
Using the avalanche method, you would prioritize your high cost debt first. That will likely be your credit card balance by targeting the credit card debt at the higher 15% rate.
If you are only able to pay $1,000 per month, it would take you 3.5 months to bring down your balance to zero.
Mathematically, the avalanche way makes sense to rid yourself of high cost debt. That debt grows faster and your total interest costs will likely be lower using the avalanche method.
The snowball method is gentler. You begin to pay down your smallest debt amounts. This should motivate you to get into the habit of paying down debt and feeling accomplishments sooner. Here, you would pay the smaller amounts in the miscellaneous total before challenging yourself with the bigger amounts at higher rates. You will likely be paying more in total borrowing costs.
Which method to use?
Guru Dave Ramsey has been a proponent of the snowball method. Academic studies back this method. The anxiety of having a lot of bills can paralyze debtors from doing anything at all. Tackling bills one at a time can be an accomplishment and is motivating.
One of the most recent studies out of the National University of Singapore by Dr. Ong Oryan, suggested that “getting rid of debt clears up cognitive functions, lessens anxiety and improves impulse control.” The study pointed out that debt impairs psychological functioning and decision-making.
One way to look at debt reduction, is to look at as a trade-off in investments. Paying down debt with higher interest rates of over 15%, is like making a 15% return! That already feels like an easy choice.
For those who are highly motivated, analytical, and ready to take on the task to lower their borrowing costs, the avalanche method is better.
It is truly a personal choice. The best choice is to get started on addressing your debt so you can move on to better financial health.
Ways to find cash to pay down debt:
- Annual tax refunds
- Sale of an investment earning lower returns than what you are paying
- Your annual bonus
- Spending below your earnings and resultant savings can help
Managing your money requires financial discipline. High debt levels disrupt our plans for wealth accumulation and need to be dealt with firmly.
Have you used the snowball method, avalanche method or some other way to effectively reduce your debt? Your comments are greatly appreciated. Thank you for sharing!
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.