How to Pay Off Your Debt

When I was growing up, one of my favorite phrases was, “as American as apple pie!” It’s one of those phrases that sticks with you whether you’re a proud American or you simply love apple pie! However, as I’ve gotten older and learned the way the financial world works I’ve created my own version of that saying: “as American as debt!” No matter how we look at debt, it's an integral part of our day-to-day lives.

Unfortunately, most Americans have taken on far too much bad debt, which eats away at their financial growth and well-being. Taking on too much debt can prevent you from achieving financial goals and put you in a position where you have no money left to live the life you want to live. To be debt-free should be your goal, using all that money you would have paid in interest to grow your net worth. Paying off your debt is actually much simpler than most people believe. It all begins with having a thorough understanding of three important variables: income, expenses, and debt.

Let’s look at a simple example: Kevin works a 9-to-5 job and brings home a monthly paycheck of $5000. His expenses total $3000 a month. Included in the expenses are things like rent, gas, gym membership, groceries, entertainment, etc. Currently, his minimum payment on his credit cards and car loan is $550 a month. Now that we know the 3 key variables, we can calculate exactly how much disposable income he has left over each month. As you can see in the table below, after deducting monthly expenses and debt payments from income earned, Kevin is left with $950 each month.

Kevin’s total debt equals $17,000, of which $7,000 is on revolving credit and $12,000 in installment payments. Unfortunately, many people perceive all debt as being equal. When you write it down with the applicable interest rates, you can clearly see it is NOT all equal! Card #1 looks bad due to the high balance, but card #2 has a full 3% higher interest rate!

Now the question is what to do with that $950 Kevin has left as disposable income each month! If he was smart, he would use that extra money to pay down some of his debt. The key here is paying down the debt with the highest interest rate first! Most people’s first inclination would be to pay down the card with the $4,000 balance. However, that card only has an interest rate of 18%. Card #2 has a balance of $2,000 with a rate of 21%. Without looking at other factors, it would be prudent to pay down credit card #2 first because it has a higher rate. If he made the minimum payments on credit card #2, it would take him 2 years and 10 months to pay off that balance and cost him $653 in interest. If Kevin took $100 from his extra $950 each month and added that to credit card #2’s payments, he would pay off that balance in 1 year and 1 month and pay only $244 in interest. Not only would he be cutting down the length of time he has to make payments on this debt by 62%, but he would also be saving nearly $400 in interest. Once he paid off the balance on credit card #2, he could now take the extra $100 plus the $80 that he had been paying for credit card #2 and apply that to credit card #1. This is called the Debt-Snowball method for eliminating debt. It is one of the simplest, most effective strategies you can begin applying today to reduce your debt.

While this is just a simple example, it illustrates the importance of understanding where you stand financially. We know by looking at Kevin’s financial situation that he has $950 to do with as he pleases every month. If he simply took half of that, $475, and applied it towards his current debt he could pay off all his credit card debt in just over one year. The question is, where do you stand financially? Have you done an analysis of all of your debt, income, and expenses? How much money could you save by simply paying an extra $100 per month on your credit card balances? How about $300? The impact of reducing your debt can significantly affect your credit score, net worth, and much more! The key is being proactive. Get involved and understand every aspect of your financial health. The more you know, the more likely you will eliminate debt, grow your net worth and live the life you want!