While you may not run into too many of them in the personal finance blogosphere, there are a lot of people out there that will tout the benefits of debt (and surprisingly, they aren’t all trying to sign you up for a loan or a credit card).
I am not one of them although in making poor money decisions in the past, I was to some degree implementing the strategies they promote. Figuring this out is what started me on my debt-free journey.
How Debt Can Work in Your Favor (Supposedly)
Here is the argument: if I can borrow money and then use that money to invest in something that will bring a return greater than what I am paying to borrow the money, I will come out ahead. Essentially, I have used someone else’s money to make myself money (the technical term for this is arbitrage).
The concern I have about this is the initial “if” in the statement above. I could make money, but I could also lose money, or make less than what I would have saved by getting out of debt sooner or by not getting into debt at all. What do I mean? Let’s look at an example.
Assume I had a debt of $20,000 with an interest rate of 5% that I planned to pay off over 5 years with monthly payments of $377. At the end of the 5 years, I would be out of debt and will have paid $2,646 in interest.
If, after putting 10% of my income toward my retirement, I am able to pay an extra $250 a month toward that debt, it means I will pay off that debt in 35 months, more than 2 years early, and only pay $1,504 in interest, a savings of $1,142. I now, after less than 3 years, am out of debt, have saved $1,142 in interest, and have an extra $627 each month to either put toward other debt or to increase what I am investing for retirement. This is a guaranteed return for paying off that debt early.
If I instead sunk that $250 in a different investment, I would need to make more than $1,142 after investing $250 for 35 months to come out ahead (if I am using this calculator correctly—and I think I am—that means I need to earn an annual rate of return of at least 6.57%). Could I earn this or more? Maybe. Could I earn less? You bet.
Borrowing money to make money may be right for you, but it isn’t for me. Or, at least, I didn’t think it was right for me. Then I figured out that by not prioritizing getting out of debt, that was exactly what I was doing.
My Turning Point
I was listening to Dave Ramsey one day when a caller asked Dave if it was a good idea to postpone getting out of debt to take advantage of a great investment opportunity. If you have ever listened to Dave you know his response was a big fat no because Dave doesn’t like debt.
Dave asked the caller if, had he been completely out of debt, he would borrow on a credit card or take out a loan on his car so that he could have money to invest. The caller said no. Dave then pointed out that by postponing getting out of debt, that is exactly what the caller would be doing. He would be “borrowing” on his credit card and car because he was taking money that he could have used to pay off those debts faster and putting it toward an investment.
I am sure that Dave had made this point before while I had been listening but for some reason this time it stuck. I was priding myself on contributing to my Roth IRA but I was doing it at the expense of paying off debt. I was also “investing” in dinners out when I could have eaten at home, clothes I didn’t need, and stuff for my condo that I was likely going to end up donating in a year’s time. I was engaging in accidental arbitrage and was doing a terrible job of it.
I was engaging in accidental arbitrage and was doing a terrible job of it.
Sure, the Roth IRA was providing some good returns but they weren’t equal to the interest I was paying on my debts. And while I think you can quantify the pleasure you get from having a nice dinner with friends and treating yourself to a pedicure, most of my money was spent on things that didn’t bring a return in fun times or less stress. It was just stuff. And food.
Stopping the Insanity!
Once I realized this, committing to becoming debt free was actually pretty easy. Here is what I did.
I took inventory of what I owed and created a pay-off strategy. I had four buckets of debt. The highest interest rates were on my credit cards. Next was my home equity loan, then my student loan, and then my car loan. The biggest loan was my student loan. I decided to tackle it last even though the interest rate was higher than that on my car because I knew paying off huge chunks of that loan would be super satisfying and keep me motivated.
I pared down my expenses. I quit the expensive gym, stopped paying for Hulu, cut back on eating out, started shopping at Aldi and more to keep my costs down. As a result, I was able to increase the amount going toward my debt each month to $2,577 or just under half of my take-home pay (47%).
I identified other pots of money I could put toward my debt. You know those Roth IRA contributions I mentioned above? I withdrew almost all of them—$15,000—and used it to pay off debt. I thought long and hard before I did so but in the end, I knew it was the right move for me. First, it created a lot of momentum in my debt snowball. Second, it was uncomfortable as hell. I didn’t like seeing the balance of that account cut in half (I didn’t withdraw the gains from the accounts because of the tax liability) and found this was in itself motivating. I want to get back to contributing to this account and the fastest way to do that is to get rid of my debt.
Other sources were my tax return, a work bonus, and the two “extra” paychecks I get each year (they aren’t really extra—I get paid 26 times a year but keep a budget based on getting paid twice a month).
If I am being completely honest, the first couple of months were rough. Time seemed to go by so slowly and I was having to deal with a lot of anger at myself for not only getting into debt but waiting so long to get serious about getting out of debt.
I didn’t miss actually spending money but I did find my frugal life to be a bit boring sometimes. I cooked at home a lot more but I don’t really like cooking. I spent more at the grocery store but still way less than eating out (this was sort of shocking because I had always told myself that as a single woman, I wouldn’t save that much by eating at home which it turned out was totally not true).
I told my friends and family what I was doing which really helped. I am probably one of the most stubborn people you will even meet and so sharing my goal almost guarantees I will achieve it: if I said I was going to do it and it is within my power to do it, I am going to get it done.
On a more practical note, I tracked my progress. This both helped me see the amount I owed was going down and was a reminder that this wasn’t going to be forever, that there was a light at the end of that long tunnel.
All this has worked. After diligently implementing my plan over the last ten months the balance on my debt went from $59,043 to $21,192. I can’t let up now (tempting as it may be) but if I stay focused I can be out of debt within the original time frame I set out for myself, 16 months.
Have you been contemplating getting out of debt? What is stopping you? What do you think your biggest challenges will be? Share your thoughts and questions below.
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