This is a series of posts from Constant Rich: Personal Finance, a book written by the author of this post.
Debt is a part of a modern man’s life and almost everyone in this world has debt. It is not always a bad thing because a debt can give you a leverage that wouldn’t be possible without it.
Imagine that you want to buy a house which costs $100,000 and you only have $25,000. A mortgage can give you a huge leverage by providing the rest of the money, allowing you to own a home without having the entire money.
This leverage can even help you earn more money. You can jump-start your business or make an investment with a higher return (if the lender allows you to do so) and end up with a profit.
However, piling up unplanned debts is a bad thing. A large debt can have a huge negative impact on your cash flow, not to mention the risk of default and losing a lot of assets.
Obviously, having a logical amount of debt, with a rational plan, is a healthy financial strategy. But, when the payments are going out of hand, you have to think about the ways of paying them back faster and more efficient and become “debt-free”, if such state is possible or the most profitable.
To pay back your debts faster and more efficient, there are some steps that you have to take.
1. No more debt
The first step to pay your debts is to stop creating any more debt. You cannot live past your debts if you keep on creating more and more debt. Even if you pay faster than creating more debt, you are still not on point when it comes to efficiency.
The only exception would be debts that you are sure that will make you more money. If it doesn't make you money, it shouldn't happen.
2. Prioritise the existing debts
After you made sure that the list of debts won’t be any longer, you have decided which ones are doing the most damage.
First, categorize your debts based on their nature. Most of your debts will be in the form of amortizing loans (mortgages, credit card debt etc.) Which means that with every payment, you pay a part of the principal and the rest goes for interest. The more you pay, the smaller will become the principle and bigger the interest portion. The other type of loans are bullet loans where you pay interest every month and pay the principal in one large lump at the end (although bullet loans are of many forms based on the deals you make). Some loans can even be a mixture of the two types.
Every loan has its standard monthly payment which you have to pay anyhow. But, mostly in the case amortizing loans, you can overpay the loan. With an overpayment, you pay a larger portion of the principal, hence paying less interest in a shorter period.
The loans that allow you to make an overpayment are of a higher priority. A loan, from a lender that does not allow you to make an overpayment, is of lower priority.
Among the amortizing loans that you can make an overpayment, the ones with higher interest rate are in a higher priority.
If two loans have the same nature and have the same interest rate, the smaller ones have the higher priority.
So, an amortizing loan with a high interest rate with a smaller amount has the highest priority.
3. Paying the debts
After you have prioritized all of your debts, you have to start paying them back (as you were). Every loan has a minimum payment which you have to pay otherwise you would default on the loan. However, you need to add a little bit to the top. It can be as small as $20 or as big as your cash flow can sustain.
You would be surprised that even a small overpayment can save you a lot of money and time. If you have a mortgage with the principal of $300,000 with the interest rate of 4% for the term of 30 years and decide to pay $100 extra every month, you would be saving $28,746 and 3 years and six months.
If in the same situation, you decide to pay $200 every month, you would be saving $50,411 and 6 years and 2 months. If you add $500 to every monthly payment, you will save $92,414 and 11 years and 8 months. It is unbelievable that how much you can save by paying your debt faster.
The same principle is true for other amortizing debts. The more you overpay, the more you save money and time.
So, you have to overpay the debt with the highest priority. However, you have to make sure that the extra payment does not negatively influence your cash flow.
If you can add some extra money at the top of the payments you make, it’s great. Otherwise, keep on with the regular payments.
As soon as one of the debts are over, you have allocated the released amount to the debt with the highest priority.
This way, the debt with the highest priority will have the highest amount of overpayment and will finish early. Then, when the next debt is paid, the entire released amount has to be added to the next debt with the highest priority. This strategy is called “snowball effect.” Once the debt with the highest priority is paid, it’s monthly payment will be added to the next one, paying it faster with the least possible interest.
This system can save you years and thousands of dollars if you follow its steps correctly. However, you have to be careful not to be tempted to create a new debt only because one or two debts of yours from the list is paid off.