How to Get Out of Debt Pt 1: Cash is King
Most people in America are in one kind of debt or another. And despite how common it is, it’s still something that induces a lot of stress and anxiety for people. No one likes to be in debt. So for most people, the first inclination is to pay it off as much as possible as quickly as possible.
But what if I told you that this may not be the smartest decision for your financial health? That, if you used a little strategy that I’m going to teach you in this article, you would have the ability to make your dollar go a much longer way than just throwing all of your good cash at your bad debt.
But before we get into the strategy, it’s important to note that there are many types of debts.
Here are a few of the most common types of debt:
Line of Credit
Student loans (see our article on student loans for more info in this)
Secured vs Unsecured debt:
The concept of secured debt vs unsecured debt is something that is named from the perspective of the financial institutions. It speaks to whether the money they lend out is guaranteed to be paid back to them or not.
Secured debt is when the bank has security that they are guaranteed to get their money back. With a secured debt, there is no chance that the bank will lose money to a lendee’s unpaid debt.
A common example of this is a secured credit card, for which you provide a cash collateral to the bank equivalent to your credit limit. So for example, if you put up $1000 cash in collateral that’s how much your credit limit will be on the card. It’s easy to qualify for because money is guaranteed upfront for the bank.
However, note that this is different from a prepaid credit card. It doesn’t mean you are charging up your card, and then using the money you put up for collateral when you swipe it. You still make payments just like any other credit card. It’s only when you can’t make payments that the banks will take from the collateral.
So in a sense, your credit score is not as important as how much cash you have. Although, the most common reason why people take the route of taking out a secured credit card or loan is to build credit. People who don’t have a good credit score can still qualify for a secured loan or secured credit card, if they have the money to put up the collateral.
When people get a secured debt they are voluntarily choosing to go into debt knowing they have the cash on hand. So you can technically already afford whatever you would buy with your secured debt, but likely there is some other motive for choosing this route - most likely because you need to build your credit.
With this kind of system, the bank just simply holds your money, and doesn’t take from it unless you miss your payments.
Unsecured debt is the most common type of credit card that people have. And as the name indicates, it is the complete opposite of secured debt. The bank runs a risk in loaning out the money, because there is no collateral to guarantee that they will get their money back.
With this kind of debt there is a different system of trust. I.e. The banks will run a type of risk assessment to analyze how much they can trust you to pay back their money by looking at your credit score and history. Approval for these kinds of loans are based on your credit score and history, And they give you a limit based on your “credit worthiness”.
Unsecured debt enables people to use money they don’t have at the time, and is still harder to obtain than a secured debt.
The purpose of this article is to help you gain efficient and effective strategies for lowering and decreasing your unsecured debts.
To get you started, here’s a tool that I frequently recommend to my clients. It will help you to calculate how long it will take to pay off debts based on the total amount of debt, the interest rate, and time. https://www.creditkarma.com/calculators/debt_repayment/
People with a lot of debt often fall into two traps
They feel overwhelmed about their debt, and so they ignore it.
They feel worried or anxious about their debt so they throw all the money they have toward paying it off.
Both issues stem from fear. Neither one of these options are good for your financial health. So, if you find yourself falling into one of these two traps, good news! I have a way out for you.
Pay close attention to the principles below.
A core principle that applies to many aspects of maintaining financial health (and interestingly, other types of health as well) is Flexibility.
So as you are creating your financial strategies, make sure you are factoring in flexibility. Some financial decisions will help you create flexibility in your finances, and others can trap you and limit your financial options in significant ways.
To get us thinking about this principle we also need to understand something called an Opportunity Cost.
Which basically means that if you use your cash (or time/energy) for something, you will lose the opportunity to use it for anything else. You can’t have your cake (to look at in front of you), and eat it too (have it inside your belly at the same time).
Now, how do these two principles apply in the context of debt?
They apply to calculating where you put your cash, and how much. Cash is the ultimate flexibility-creator.
They say “Cash is King” and there really is something to that.
Let's demonstrate this with an example.
Say you want to buy a $10,000 Car.
You have 2 options available to you.
Use cash to buy the car outright.
Use debt, which will result in interest.
At first glance, this looks like cash is obviously the better option. Who wants to pay more than what they need to right?
Well, when you use cash you lose the flexibility of having that liquid cash available to you (for investing, emergencies, etc). If you get a loan you will still have your $10,000, which you might even be able to invest in something that will bring you greater gains than what you would lose on the interest. So you net a profit instead of a loss.
Now don’t get me wrong, paying cash is not necessarily a bad thing - the only thing is that you lose flexibility. This is very important to consider, especially if you have no more cash after this.
Here’s a real-number scenario to demonstrate my point.
Let’s say you have a $10,000 of debt with a 5% interest rate.
→ if you pay it off over 5 years = $1320 in interest
You also have liquid cash $10,000. You could take the cash and use it to pay off that debt and be square. OR..
You could put that $10,000 into a Roth IRA with an expected growth rate of 7%
→ in 5 years it will grow to $14,099 = $4099 of growth
If you calculate the difference, investing that $10,000 would have made you more money than the negative interest you would have paid on the debt, by a net gain of $2779
→ $4099 growth - $1320 interest = $2779 net growth
In this case, you can take your time paying off the debt because the interest rate is so low, and the opportunities you took with your cash. Instead of throwing it all at the debt right away, it is earning you capital that is going to help you gain more money than you are losing to the interest.
That’s a win.
For this demonstration, let’s use all of the same numbers as in example 1, except the interest on the debt is now 20% (the average interest rate of a consumer credit card).
In 5 years, the amount of interest on the $10,000 debt would be $5894.
In this case, it’s better to pay the debt off more quickly.
The purpose of the demonstration above was to prove that sometimes keeping cash or taking another financial opportunity is more beneficial than paying off debt as quickly as possible.
You should of course always be paying off your debts, by meeting the minimums. But if you’ve got cash above and beyond those minimums, paying it in bulk directly toward your debt might be crushing your flexibility to take advantage of opportunities that will not only get your debts paid off, but bring you a return!
Again, remember that everyone’s situation is different. If you want my help with your debt situation I am here for you. Just book a free consultation and let’s get to work on getting your debt strategy into a good place.
More debt crushing strategies coming to you in a follow-up article for part 2 of "How to get out of Debt". So stay tuned!