How good would life be if you were debt free? No mortgage payments, or car loans. No credit cards. Imagine the weight off your shoulders. The financial freedom you would gain. The financial autonomy.
Of course many people, probably most people, achieve debt free status over their working life. This episode is not for those who have already achieved this milestone.
This episode is for those of you on the journey. For whom debt obligations comprise a significant portion of your regular income.
We’re going to look at some strategies you might be able to use to get to debt free status quicker. And that acceleration in clearing your debt brings you closer to whatever your financial autonomy goal is.
For the purposes of this article, I’m going to assume you, the listener or reader has debt, and debt you’d love to see the back of. Given the title of this post, I’d imagine self-selection should deliver us this outcome.
In the modern era, establishing yourself financially without taking on debt is near impossible. The only way I could imagine this happening is either if you were fortunate to be born into a wealthy family who bought you a home, or else you never owned anything, perhaps rented your whole life.
Most people I meet will have a mortgage, or if not a mortgage, then at least a loan for a car, with the hope or intention of having a mortgage one day. Very often there are credit cards as well. Sometimes there are debts for whitegoods or a holiday.
Debt is not evil. Borrowing to buy your house is likely to have been a smart investment. Over time the home’s value rises and you hopefully reduce your debt, so that you build up equity in your home. One day you will pay off the debt entirely and will have a roof over your head without having to find mortgage or rent payments each month – incredibly liberating.
Debt to fund consumption on the other hand is not so wise, but who hasn’t done it? Financed the brand new car when a 2 or 3 year old vehicle would have been significantly cheaper and still done the job. Or come back from holidays with a credit card bill you couldn’t pole vault over. I’ve been there and I’m assuming you have too.
So how can we get these debts under control and fast forward your journey towards financial autonomy?
Let’s say you decided you needed to lose a few kilo’s. What’s the first thing you would do? Would you jump on the bathroom scales and weigh yourself? That would seem to be a sensible first step. You need to know your starting point to understand the task ahead – do you need to lose 5 kilograms or 20? You also want to measure progress. You want to know if the actions that you are taking, say increasing your exercise, is paying dividends.
So in planning to get your debt under control the first step is to establish where you are now. I’ll put in the tool-kit for this episode a table you can fill in to help make sure you don’t miss anything.
In putting this together, you’ll get an accurate picture of how much income you need to generate each month to cover your debt repayments, the different interest rates on each loan, and your total loan balance.
It’s also helpful when putting together your list of debts, to establish whether they’re tax deductable or not. Later, we want to decide which debt to focus on clearing first. Typically you’d focus on the debt with the highest interest rate, but if it were tax deductable, that could alter the thinking, so it’s useful to know the tax status of each debt.
If you have any debt that is tax deductable, you’ll probably already know about it, but to clarify, tax deductable debt arises when the thing you bought with the money you borrowed, generates taxable income. The most common example is an investment property. You borrow to buy the property, and the property then brings in rent. The rent is taxable, and the interest on the debt associated with buying the property is tax deductable.
Tax deductable debt could just as easily be for buying shares, a business, and in some cases a vehicle where you use it to generate income.
Something that comes up from time to time when ascertaining whether a debt is tax deductable, is which asset the debt is secured against, versus the thing you bought with the money from that debt.
The debt on your home is not tax deductable – your home doesn’t generate any income. But what if you buy another home, and keep your old place as a rental. You will borrow against you previous home and use the money to buy the new home. Now people will often assume that given the debt is against the property that is now a rental, it would be tax deductable, but that is wrong. Tax deductibility has nothing to do with what asset is used as security. Tax deductibility is determined by how the money that you borrowed was used. In this case the money was used buy your new home, something that won’t generate any taxable income, and so the interest on that debt is not tax deductable.
If you’ve got any uncertainty as to whether a debt is tax deductable or not, best to give your accountant a call to clarify.
Anyhow, back to your list of debts and their details. You’ve now got your starting point. If you want, you could also write down a list of your assets and their values, and then subtract the total debt value from the total asset value to determine your Net Worth. For some people, tracking Net Worth can be an empowering way to reinforce the positive progression they are making towards financial independence.
So which debt to focus on first? Well logic would dictate that you’d start with the most expensive debt. Let’s assume for the illustration that is a credit card debt.
For the time being we’re going to leave the other debts as they are – just keep paying the repayments as you are. Our focus will be clearing this credit card.
So the low hanging fruit is to pay more off this debt. A tax return, a bonus, pay rise or gift.
Next, could this debt be refinanced at a lower interest rate? This is often termed debt consolidation. Now approach this with caution. Debt consolidation can certainly lower your debt costs. But some people simply use it as a way to take on more debt, so don’t head down this path unless you’re serious about getting your debt under control.
The other potential trap with debt consolidation is the length of the new loan.
Check out this example:
Loan amount for both is $20,000
Loan 1 is at an interest rate of 10%, with a repayment term of 3 years.
Loan 2 has a lower interest rate of 5%, and with a loan term of 10 years.
So which loan results in you paying the least interest?
Loan 1: $6,620 of interest paid by the time the loan is paid off in 3 years.
Loan 2: $12,577 of interest paid by the time the loan is paid off in 10 years.
So the key message here is consider debt consolidation, but be wary of solutions where the loan term is stretched out significantly. The banks or lenders aren’t your friend. They survive by making money from you, so if you’re considering debt consolidation, make sure you understand your numbers – get some outside help if you need it.
With credit cards, something you could look for is deals where you can transfer your card from one provider to another where they offer an interest free period on balance transfers, often for 6 or 12 months. Now again, the credit card provider isn’t your friend. They’re offering this in the hope you don’t pay off this debt, and they’ll make lots of interest from you at the end of the interest free period. So be sure to really knuckle down on reducing the debt during the interest free period, and when that period ceases, look around to see if you could shift to another credit card provider with a similar deal.
Okay, so you have your debts listed, and you’ve prioritised them from most expensive to least expensive. You’re keeping then all up to date, but focusing any extra repayments on the most expensive one first. Awesome.
Progress too slow for you though?
The steps so far have been fairly painless. But if you really want to make an impact on your debt, there’s one more thing you’d need to do.
No lasting progress will be made unless you get your budget under control. The hard reality is that if your debt challenges relate to personal debts like credit cards and car loans, you’re in debt because you’ve been spending more than you’re earning.
You need to recognise and acknowledge that, and then take steps to rectify the situation. What non-essential expenses can you cut? Subscriptions for magazines, pay TV, or software. Memberships to the gym or sporting club – would it be cheaper to just pay when you use the facilities? Clothing. Eating out.
After housing, food is likely to be your next largest expense item. Reducing what you spend eating out is the most obvious way to reduce expenses – bring your lunch from home and just eat at home whenever you can. When buying your groceries, is there any branded products that could be replaced by no-name equivalents. Think of other ways to play it smart – you feel like some beef for dinner, but do you really need that Eye Fillet steak? Rump steak is about half the price and mince around a quarter. Whole chickens are much cheaper by the kilo than chicken pieces. Just watch a 3 minute video on Youtube on how to break down a chicken and you’re away.
Think how you could save some extra dollars and then send that money towards your debt. The more you reduce your debt, the less interest you pay to the bank, which means even more of what you pay each month goes towards reducing the debt, and so your loan reduction strategy just snowballs until one day …. YOU’RE DEBT FREE!!!!
I hope this content has been helpful in getting your debt under control. Be in touch if you need any assistance. As with all of the Financial Autonomy posts, there is a free toolkit for you to download to help you take action. In this one I’ve got the debt table that I mentioned earlier so you can get on top of things debt wise, our Budget Tool and also some useful books and web sites.
Next episode we will be looking at Procrastination, so be sure to subscribe to the podcast to ensure you don’t miss out.