By Jared Dillian of Mauldin Economics
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Ordinary problems don’t disappear during a crisis.
Take debt, for example. If you were saddled with debt at the beginning of March, you’re still saddled with debt, and likely more of it.
Where the heck do you even start?
Step one is to pull your head out from under the covers and tally up your debt. All of it. No matter how scary that might be.
Here’s an example to get you started:
Total debt: $440,600.
OK, you’ve faced reality. That is a big step in the right direction. Now you have to decide which debt to eliminate first.
There’s some bad advice out there about this. Some personal finance gurus recommend the “snowball method,” where you pay off the debt with the lowest balance first. It’s an easy win, and that’s supposed to motivate you to keep going.
I don’t like the snowball method at all. If you tackle the smallest debt first, it might not be the debt with the highest interest rate, and you’ll end up paying more in the long run.
Secured versus unsecured debt
A better way to tackle things is to look at your secured debts and your unsecured debts.
The mortgage and car loans are secured debts, meaning they’re backed by property. The bank will kick you out of your home if you don’t pay your mortgage. And the repo man will tow away your car if you don’t pay your car loan. Both are bad scenarios.
The credit card debt is unsecured debt. If you don’t pay the bill, eventually the account will go into collection, and you’ll get a lot of unpleasant phone calls.
You could try to consolidate, but it’s hard to make defaulted credit card debt go away. You might reach some sort of a settlement, but eventually, you will have to pay it unless you declare bankruptcy.
Then you’ve got student loans , which are their own special beast. Student loans cannot be discharged in bankruptcy. They just follow you around forever until you do something about them.
So, where do you start? Well, it’s hard to pay down debt if you don’t have a place to live or a car to drive to work.
Credit card debt carries higher interest rates than secured debt. So in theory, you should pay your credit cards off first. But if you lose your house or your car, or both, you’re really stuck. So, it’s generally a good idea to prioritize your mortgage and your car loan first.
Once you’re on top of the priority secured debt, the student loans are next. Then you focus on unsecured debt with the highest interest rate.
Not the snowball method — the highest interest rate.
Sure, the snowball method might give you some sort of psychological victory, but you lose money that way. You pay more interest that way. How is that good?
Say you have a $2,000 balance that carries an 8% interest rate, and another $18,000 balance with a 21% interest rate. If you hack away at the smaller balance first, you are literally losing money every day. It might not be as satisfying to pay off the bigger balance first, but that is what you need to do. Take a big chunk out of that thing every time you get paid.
Keep in mind, you have to make the minimum payments on all of your debts during this whole process. The priorities we just covered are for debt elimination. It’s a system for ranking which debt to throw every last penny at until it’s gone.
Debt is holding you back
A family member recently told me he had mid-five figures in credit card debt. This guy is paying $7,000 a year just in interest, which is terrible.
This is a very common problem, but you have to face facts: If you are in debt, it is holding you back from fulfilling your potential. But you can get your life back.
I get it — buying stuff is fun. You get cars, jewelry, vacations. But financial freedom is also fun. So is investing. You get to buy stocks and watch them go up ! But you have to tackle your debt first or you’ll never get there.