If you are debt free or have a history of creatively and successfully employing leverage to grow your wealth, you can skip this post entirely and read one of our other posts. Our intention with writing this post is to enable readers to learn how to start off with a negative net worth and then plan and execute their way towards achieving eventual financial independence. We are not the supercritical type and believe that a large proportion of people are in the undesirable financial positions they are in due to difficult life events that left them with no choice but to get into the burden of a large debt load – losing their job during a large recession, a sudden medical development, not being able to afford to pay for college, etc. All of that is fine and while we are certain that smarter decisions could have been made in each instance we believe that there is no point delving into the past again. With that being said, if you are currently buried under a substantial amount of debt that is not tied to building any revenue stream then you need to stop everything you are doing and figure out an actionable plan to become debt free.
The Numbers Behind Debt: It is important to always think of money in % terms. The fundamental mathematics of compound interest is one of the most important facts of life and will be critical in building any sort of meaningful wealth. The Rule of 72 is a simple mathematical formula that best illustrates how compounding works. If you take the number 72 and divide it by the rate of return, you will get a pretty reliable indicator for how long it will take an investment to double in value. As an example, if your rate of return is 8% (72/8), then it will take nine years for you to double your money.
This is great for you assuming you are headed in the right direction, but the issue with debt is that you are traversing in the wrong direction with compounding. Even if you have a really low interest rate at 4% it still means you will be indebted by an additional 48% in just a single decade if you aren’t paying off your debt. To reiterate again, debt can be a great thing if used with the sole purpose of building up revenue streams, but for all other purposes it should be treated as a code-red financial emergency.
Now let’s go through how you can responsibly bring down your debt load.
Least Desirable Scenario: Considerable Credit Card Debt & No Payments
Look to accumulate cash as soon as possible, delay some payments and then make a single one-time payment to pay off your debt. Yes, we mean it. If you are in a situation where you have a high debt load then it is in your interest to keep on delaying payments until you are permitted to have a percentage of the outstanding debt forgiven. As an example:
John Smith owes $25K in credit card debt, avoids making any payments and now contacts the credit card provider to reach a settlement on his debt. Eventually, they reach a consensus to forgive $10K of the debt. John can now reduce his debt load substantially. He will still be required to pay taxes on the forgiven amount ($10K * income tax rate of 20-25%) or $2K + $15K in outstanding debt. John has now reduced his debt load by $8K or 32%! As a side note, when determining how worthwhile a potential deal is, always measure it in percentage terms. Make the full remainder of the payment and wipe the debt off the books.
Be sure to go through this route cautiously with the right debt settlement agency as you want to do everything possible to ensure that you can get your credit score back up in the long-run (there is no avoiding a hit in the short-term). Keep in mind that if you skip making your credit card payments for nine months straight then it can plague your credit report for the next seven years. Once you do manage to pay off your debt in full ensure that you retain the letter from your creditor confirming that you have paid/settled the debt in full.
This option is only desirable when you find yourself in an ugly scenario of high debt + high interest-rates and we do not recommend skipping bill payments when the situation is more manageable. You will know when you are in a shitty position that requires this extreme measure when you are barely able to sustain yourself on your existing income and the creditors are constantly calling you (if they are speaking to you in a friendly tone it is an indication that you are in position to negotiate a worthwhile settlement).
How to Manage the Settlement:
- Call the day before the end of the month as the last collection day corresponds with the final day. The ultimate goal is to get the one-time payment to 50% or lower, so start with a settlement rate in the range of 25%.
- Try to get a cease and desist letter that stops them from contacting you via phone and other direct means. Instead, insist on communication in writing via post. This is typically good for about a week and if they ignore this you can follow with a lawsuit. It is highly probable the company will agree to settle your account.
Normal Everyday Scenario: Minimal Level of Debt
Most people these days have a small workable amount of credit card debt which should be dealt with in accordance with their existing savings rates. If we make the assumption that you are currently employed the numerical computations are again determined by percentage terms.
Computing the Returns (Example):
Jim Jones has a credit card statement with a 7% interest rate. He needs to make a decision between his credit card debt payments, 401K as well as his monthly living expenses. Since his employer does a dollar-for-dollar matching plan, he should max out the 401K match and then utilize the remaining money to pay off the debt. In order of priority, it should look something like this:
401K Company Match (100%) → Credit Card Debt Payments (7-12%) → Save up 3 Months of Basic Rent & Living Expenses → Investments (5-10% Returns over the Long Run)
Categorizing Debt Into Multiple Tiers:
If you have multiple layers of debt then you may need to look into keeping payments for certain notes to the absolute minimum. For example, Steven Smith has $6000 in debt split across four debt notes:
- $1500 debt at 13%
- $1500 debt at 18% but interest-free for the first 12 months
- $1500 debt at 8%
- $1500 debt at 2%
In this scenario Steven should pay off the 13% debt first, then focus on paying off the 18% debt until the 1-year period expires, then pay off the 8% debt. He should, however, leave the $1500 debt payment at 2% untouched as it does not keep up with the long-term average inflation rate. This means he will be better off financially by reinvesting his cash into bonds and dividend paying funds at 4-7% (although based off the 9% inflation rate of the previous year even this is not the most rational decision). As long as your debt load is not outpacing inflation there is no reason to pay it down. With that said, in the majority of cases you will be contractually obligated to pay off the debt load so once again be sure to run through the numbers in percentage terms.