Debt can often be the shackle and chain that restricts people from reaching their financial freedom. Today I’m going to explain debt and show you two approaches to eliminate your debt.
Debt occurs when you borrow money from another person/institution, typically a bank which comes with terms and conditions that dictate that you pay back the amount borrowed, often with additional interest that compounds over time.
The excess interest that you pay in some instances can be so much that you ultimately pay more than twice what you originally borrowed. This extra payment can be disastrous on things that depreciate in value such as phones and new cars. The reason debt on depreciating items is so costly is because as your item lowers in value over time, you still pay for its full initial cost, with an added interest rate.
If you use a credit card with an interest rate of 16% to purchase the latest iPhone (Currently the iPhone 11 Pro Max) which is currently selling for $1,900. It would take you 11 years and 2 months of paying the monthly minimum amount to cover the total costs of your phone. By the time you have paid off your phone, you would have spent $2,774 on interest and credit card fees, or a grand total of $4,674.
That’s paying the bare minimum, which I understand not everyone does but it can illustrate the extent to which debt can grow with that negative interest compounding over time. However, let’s assume you paid it off at a much faster rate and threw say $100 a month at it. If you were to save up and buy the iPhone outright, it would take 1 year and 7 months. However, if you ended up using your credit card and paying off $100 each month, it would end up taking you an additional four months to cover the cost of the phone. During which you’d spend an extra $406 on interest and fees.
Add into this the rate of depreciation, with most iPhones dropping anywhere from 25-50% after a year of purchase and you can see how dangerous getting loans for depreciating assets can be. The debt grows while the value of the item diminishes.
So let’s say that you have multiple forms of debt and you want to get rid of them, what’s the best approach? There’s are two main approaches when it comes to debt reduction, the Snowball Approach and the Avalanche Approach.
The Snowball Approach involves tackling the debt with the lowest amount owing first and building up momentum as you pay off smaller debts faster than larger ones. The main idea behind this is that you get the psychological benefits of completely eliminating one of your debts, giving you the mental momentum to continue tackling the larger ones.
If you struggle with self-control or if you are a person who likes to tackle things one at a time, this may be a better strategy for you. However, the avalanche approach while providing less immediate gratification can result in you paying less debt.
The Avalanche Approach involves tackling the debt with the highest interest rate first, as this is the debt that is charging you the highest amount per dollar. Statistically, this is the better method as you are reducing the overall amount that you will pay in the long run. However, people tend to struggle with this one as it can be hard to see small debts constantly eating away at your income while you slave away to tackle what may be a much larger figure.
If you have the willpower to follow this approach, it will save you more money. If you don’t feel that you can follow this method, then use the Snowball approach. Paying off debt at a slower rate is still much better than avoiding it.
Regardless of what method you use, it’s important that you start taking active steps to get out of debt as fast as possible. Set aside as much money as you can and use it to aggressively pay off your debt. The negative interest that you generate from credit cards and loans will always outweigh the positive interest you generate from savings accounts. Set aside an emergency fund to cover any unforeseen expenses, but prioritise your savings towards covering that debt. If you need further information on how to save money or increase your savings, I cover it in detail here How to Save