The less debt you have, the less financial risk you’re exposed to. After you’ve paid off your bad debts, plow the money that’s been freed up into getting rid of your mortgage as quickly as possible.
Imagine this.
What if housing prices fall by 50% as they did in many areas back in 2008? And what if jobs dry up and many people, including you, have decided that the best option is to move somewhere else with a better job market?
If your mortgage has been paid off, even if you had to move to a better job market on short notice and sell your home for less than you paid for it, you’d probably be okay (granted, not happy about it, but you certainly won’t have to worry about going bankrupt over such a thing). Whereas for someone who hasn’t paid off their home, being forced by circumstances to sell during a price crash could be stressful if the balance owing is more than the proceeds generated by selling it.
Action step
If you have a mortgage (or are thinking of getting one) run the numbers, assess the risk, and find out if it meets the three criteria for good debt in your unique situation.
If it does, that’s great. But if it doesn’t, you need to take action.
What to do if your mortgage is bad debt
If you have a mortgage and come to the conclusion that it’s bad debt, you need to get rid of it as soon as possible. Here are some options for doing that:
Consider selling it and cutting your losses now if the following three criteria are met:
- you don’t think it’s likely that you’ll be able to hang onto the home long enough for it to turn a profit compared to renting, and,
- the losses are expected to continue to grow with time, and,
- you won’t suffer any negative financial consequences such as bankruptcy if you do so
Consider keeping it and paying it off ASAP if the following two criteria are met:
- selling it would ruin your credit because it would force you to declare bankruptcy (for example, if you owe more on the mortgage than the house is worth and you can’t afford to repay the difference to the lender), and,
- you can afford to continue making payments
Remember that if your current mortgage is bad debt, that doesn’t mean that would be the case with any and all mortgages.
For example, say your mortgage is bad debt because you accidentally bought a home that required mountains of expensive repairs that killed any hope of ever making a profit over time. If you bought a well-maintained home that only required normal levels of repairs, that could be enough to turn a mortgage into good debt for you.
Or, say your mortgage is bad debt because you bought a home that’s too expensive. If you sell it and replace it with a less expensive home, the numbers may work out in your favor this time and turn a profit over the long term compared to renting.
Don’t assume all mortgages are good debt, or that all mortgages are bad debt for you. Run the numbers and assess the risk each and every time — every mortgage situation is different, even for the same person.
What to do if your mortgage is good debt
Pay it off as soon as you can, using the Power Pay Off Plan that you’ll learn about in a future chapter.
Summing up
There’s no one-size-fits-all rule for how much you should spend on a home or how high of a mortgage payment you can afford to make. Rules such as the 43% limit for a debt to income ratio or a 30%-of-gross-income upper limit for mortgage or rent payments should not be accepted as automatically affordable for you. Unfortunately, there are no short cuts here. The only way to know for sure what your personal limit should be is to run the numbers. Track your earnings. Track your spending. Make an informed decision about what you can afford after you’ve gathered all the facts.
Figure out if your mortgage is good or bad debt in your situation, and take action based on that. Everyone is different.
Now that you know the difference between good and bad debt, it’s time to find out the best way to pay it off. And that information is what you’re going to be reading about in the next chapter.
The Power Pay Off Plan
(And How Sam Saved 20 Grand)
“Let him who would enjoy a good future waste none of his present.” Roger Babson
I’m about to share with you how choosing the right method of paying off debt could save you over $20,000, require you to put down the same amount of money each month as the wrong method, and allow you to be debt-free six-and-a-half years sooner.
How Sam saved twenty grand
Obviously, your debt numbers will be different from Sam’s, but the lessons in this story will apply to everyone. Read on and see how big savings can be had under the right circumstances.
Sam accumulated a total of $80,000 in debts and is trying to decide on the best way to pay it all off.
His minimum payments add up to about $1276 per month, and if he sticks with that he’ll have everything paid off in 20 years.
But he recently started a side business that’s already bringing in an extra $200 a month. His plan is to put that extra cash towards paying down his debts faster — and with the extra money he’s earning, he can now put $1476 per month towards debt repayment (i.e. $1276 + $200 = $1476).
A big decision
Sam is facing a choice between two strategies of paying everything off.
A very important point is that no matter which debt repayment plan he chooses, he’ll still be putting about $1476 per month towards paying it all off until he’s finally debt-free.
The first option he’s considering is to tackle his highest interest debts first. In theory, that should be the most cost-effective way of paying down his debts, although he’s not sure if the savings will be significant or not.
The second option he’s considering is to pay off the smallest debts first. Once those are gone, he could move on to tackling the larger and more intimidating ones.
Which option would you choose?
His friends are all telling him that this second option is the way to go. They say it’ll feel fabulous to get rid of a new debt every few months — the smaller ones can be paid off more quickly — and they say this series of small wins one after the other will help him to stay motivated enough to continue making payments until he’s debt free.
His investment advisor tells him he’s heard of people having great success with this method too, and it’s known as the Snowball Method of paying down debt.
Sam thinks that this sounds pretty good. He’s excited to be on the verge of finally doing something to better his finances and is determined to see this through until the end.
Human nature is a funny thing sometimes
Interestingly, research shows that many people will choose the Snowball Method that Sam’s friends and investment advisor are so casually suggesting, even if it hurts us financially.
For some reason, our instinct is to minimize the number of debts that we have to manage. Perhaps this is partly because with every debt we pay off, we get rid of another annoying monthly bill that we have to deal with — and that’s an attractive outcome in the typical fast-paced, busy, and often stressful modern lifestyle.
But the unfortunate fact is that this can sometimes cost us big bucks.
Time for a bombshell
I like to call the first option — paying off debts with the highest interest rates first — the Power Pay Off Plan.
Luckily for Sam, the loan officer at his bank crunched some numbers and suggested that he consider the Power Pay Off Plan. When Sam found out just how much money he’d save, and how many years earlier he’d be free of debt, he was stunned and horrified that he’d almost chosen a path that would have wasted twenty grand of his hard-earned money.
It turns out that if Sam chooses to use the Power Pay Off Plan, he’ll be debt-free six-and-a-half years earlier and save over $20,000 compared to using the Snowball Method.
How is that possible?
Here’s the lowdown on Sam’s debts, including the details that his friends and investment advisor failed to consider — the interest rates on his debts.
Sam has three bank accounts at three different banks. Each of them offered him a line of credit when he opened the account.
He made full use of those lines of credit, maxing them out, and now owes a total of $30,000:
- $11k to Bank of America
- $10k to Charles Schwab Bank
- $9k to Wells Fargo
The interest rate on each of those lines of credit is 4%.
Sam also has two credit cards, each charging him 30% interest on any balances. He’s managed to max them both out and now owes $20,000 to his MasterCard and $25,000 to his VISA.
Number crunching time
To keep this example from turning into a mess, I kept things simple. The interest rates on his credit cards are the same so that I can combine the credit card debt into one lump sum for calculation purposes. Ditto for the lines of credit.
And neither his credit card companies or banks will penalize him for paying off these debts sooner than the maximum 20 years allowed in this fictional scenario.
So now that we have those assumptions out in the open, here is how things go down.
The sum of the minimum monthly payments owing on his credit cards is $1065. The sum of the minimum monthly payments owing on his lines of credit is $211. All of his debts are due to be paid off in 20 years at that rate.
The question we’re dealing with here is whether or not Sam should put the extra $200 a month he’s earning from his side business towards paying down the lines of credit or the credit cards.
Snowball Method
If Sam chose this method, he’d be kicking himself for a long time after finding out how much money he wasted.
He’d spend 99 months paying $411 a month (total) towards his lines of credit, and $1065 a month (total) towards his credit cards.
At the end of month 99, his lines of credit would be paid off.
He’d spend the next 51 months paying $1476 a month towards his credit cards. (At the end of month 51, his credit card debts would be paid off).
In total, he’d have spent 150 months and $116,031 to pay off those debts.
Power Pay Off Plan
If Sam chooses this method, he’ll end up debt-free sooner and be twenty thousand dollars richer.
He’ll spend 51 months paying $1255 a month (total) towards his credit cards and $211 a month (total) towards his lines of credit.
At the end of month 51, his credit cards are all paid off.
He’ll spend another 21 months paying $1476 a month (total) towards his lines of credit.
In total, he’d have spent 72 months and $95,485 to pay off those debts
Important takeaways
No matter which plan he chose, he’d be putting the same amount towards debt repayment every month: $1476.
But with the Power Pay Off Plan, he ends up paying off his debt six-and-a-half years sooner and saving over $20,000 compared to using the Snowball Method.