The ideal state of personal finances is to never get into debt in the first place. That was the advice given by influential investor Warren Buffet to a 14-year-old shareholder at the 2004 annual meeting of Berkshire Hathaway, the multinational holding company Buffet chairs. “It’s very tempting to spend more than you earn,” Buffet told the young investor. “It’s very understandable. But it’s not a good idea.”1
Hopefully, that teenager heeded Buffet’s recommendation. Many people, however, find themselves in serious debt and feel hopeless about their ability to dig themselves out of what can feel like a deep financial hole. High interest rates and late payment penalties exacerbate the problem. Making minimum payments only succeeds in kicking the can down the road.
The question remains however – how do we crush debt in 2020?
Photo by Blake Wisz on Unsplash
Many people owe money
If you are in substantial debt, you are not alone. Australians have some of the highest personal debt levels in the world, amounting to a total of roughly $2 trillion dollars. Down under debt can be largely attributed to mortgages, investments, personal loans, student loans and credit card use.2
In the U.S. the total consumer debt is a staggering $13.86 trillion dollars. This includes mortgages, credit cards, auto loans, student loans and medical bills.3
Not all debt is bad debt. Good debt – such as a home loan – helps you build long-term wealth (although buying a house you can’t afford does not fall into the good debt category). Bad debt does the opposite and refers to things like purchases of consumer items that depreciate in value over time.
Three steps to crushing debt reduction
Whatever your level or source of debt, following my three-step system will help you get out of that financial hole and back onto solid ground. The three steps are:
- Know what you owe
- Set priorities
- Establish a plan.
Know what you owe
Coming to terms with exactly how much money you owe can be overwhelming. In fact, some people avoid taking a good, honest look at their financial situation because of the anxiety it provokes. If you genuinely want to take control of your personal finances, it’s important to get beyond that reluctance. Before you can address your debt problem, you must have an accurate accounting of it.
Review and make note of your current situation. Do you have credit cards with outstanding balances? A car loan? A mortgage? What is the interest rate on each? For car loans and mortgages: how long until they are paid off?
In terms of other expenses, tracking your financials for a month will give you a better understanding of income and expenses. Are there areas where you are spending more than you need to, such as on dining out or recreational activities or even subscriptions that you no longer require? Making note of everything you spend for four weeks may reveal where costs can be reduced – and that is money which you can apply toward debt.
And finally, is your income steady or is it seasonal or freelance? Are there additional revenue streams you can create? Perhaps – like so many people – you are unemployed due to the coronavirus pandemic. If that is the case, it is even more crucial that you examine your expenses and determine which ones can be decreased or eliminated.
Set priorities: put credit cards with high interest rates at the top of your list
Re-order your credit cards so that they go from highest interest rates to lowest. Prioritise paying off the cards with the highest interest rates first. This does not, of course, mean skipping payments on other cards and incurring the penalties that would go along with late payments.
Establish a debt reduction plan
Target the credit card that has the highest interest rate. Commit to making more than the minimum payment on it until it is paid off. Do not use it to make any new purchases. Instead, for necessary purchases, use a credit card with a lower interest rate. Even better still, use a debit card or even cash if it is available.
(Note: Some people prefer to list credit card debts from lowest amount to highest amount, and to pay them off in that order. It is easier to pay off a smaller debt and they get a psychological boost from seeing an item vanish from their ledger. However, using the interest rate system will reduce overall debt faster).
It may be worthwhile to contact your credit card issuer and see if you can negotiate a lower interest rate. You may get a “no,” but if you’ve been a loyal, longtime customer, you could get a positive response. It doesn’t hurt to ask.
Alternatively, if your credit card debt is really getting out of hand, a balance transfer deal could be a good way to clear your debt and get your finances under control. A balance transfer is a way of moving some or all of your credit card balance from one card to another. The debt you move to the new card attracts a lower interest rate (or even no interest) for a certain period (called the promotional or honeymoon period). However, it is very important that you pay it off within the promotional period, or you could end up losing even more money and increasing your financial stress.
Take a good look at the interest rates on your car loan and mortgage. Would it be worth it to refinance them to get a lower rate? Keep in mind: there may be closing costs involved in refinancing, which could make the process less worthwhile. Look into this first. If you decide to pay off your mortgage faster, you can make bi-weekly payments or an extra payment each year or pay an additional amount each month toward the principal.
If you lost your job due to the pandemic and are having trouble making car or mortgage payments, contact your lender to discuss your situation. Many loan servicers have put provisions in place to assist customers who are in dire financial straits.
Once you are out of debt, stay out of debt
Unfortunately, many people who take the necessary steps to get out of debt soon find themselves right back in a financial hole – one they’ve dug for themselves. This is because they did not change the habits that created their financial difficulties in the first place. For example: once they feel free from the heavy weight of debt, some people go right back to using credit cards to pay for things they can’t afford.
If you need motivation for changing poor spending habits permanently, consider this: all the money you’re saving by not paying high interest rates on credit cards can be used for investing. Instead of servicing your debt, that money can help grow your wealth.
Next steps, or staying out of debt
Your PROFITABLE ACTION STEPS this time around:
- Cut out unnecessary expenses. Put the money you’d spend on them toward investing, so that you can enjoy a financially comfortable future.
- Get rid of credit cards with high interest rates. Longer term, aim to use a debit card instead.
- For the credit cards you do continue to use: pay off the entire amount each month, in order to avoid paying extra for interest. Set this up via your financial institution as an auto payment
- Try to negotiate better arrangements on all your outstanding debts – if you do not ask, you will not receive. This may even require moving to a completely new lender. For example. If you can negotiate a reduced interest rate, this may save you thousands of dollars on a sizeable mortgage.
The next blog post will be: Who is Warren Buffett?.
Have you read my article on the 2020 gold rush?
Stay safe, healthy and wise and most importantly of all, take ACTION.