FI Step by Step: Step 8, Work to Become Debt Free

Step 8, Work to Become Debt Free

I’d like to get back to outlining the steps I recommend for becoming financially independent.  It’s the path that my wife and I are following after doing a tremendous amount of research and studying personal finance.  

Today I’d like to talk about working to become debt free.  With the coronavirus pandemic, I know this might be the last thing on some people’s mind.  Many people are just trying to survive.  However, this might be the perfect time to start planning for your financial future, especially if you have more time on your hands.  One of the silver linings of sheltering in place is that it gives us time to get to many of the things we felt we never could before, like evaluating our finances. 

Why Step 8?

Step 8 of my recommended steps to achieve financial independence is work to become debt free, with the exception of your home mortgage.  I know what you’re thinking.  Why did I wait all the way until Step 8 to tell people to work to become debt free?  Many financial step by step plans have you pay off your debt right away, in the first step or two.  Let me try to explain my rationale for the order of the steps I’ve outlined.

I have tried to recommend a plan that would create a blueprint for meaningful, long lasting change.  The first step in that process is to figure out why in the world you want to do this.  If you don’t have a strong purpose pushing you forward, you are likely to fail and quit.  So in Step 1 I recommended that you Define Your Why?

Next, I felt it was imperative that you determine your current financial position by calculating your net worth in Step 2. How can you progress towards FI if you don’t even know where you’re starting from?  These first two steps can be done at the same time in one day.

After you determine your starting point, in Step 3 I recommend you spend some time (hopefully a few months) developing a thorough understanding of your financial behaviors.  How does money come into your life?  And how does it leave it?  This will give you the necessary knowledge to create a financial plan for yourself in Step 4.  If you don’t have a thorough understanding of your income and expenses before you create a financial plan, the plan is likely to be inaccurate and doomed for failure.  

When you get to Step 4 and create that plan, if you have some debt slowing you down (as most of us do), hopefully you create some form of debt repayment plan as part of your overall strategy.  But before you focus all of your energy and jump headfirst into a debt repayment plan that could take months or years to complete, I recommended you do a few things up front.  

In Step 5 I recommended you get the proper insurance in place for yourself because you can never predict when catastrophe could enter your life.  It makes no sense to me to try and pay your debts off completely, which again could take months or years, before making sure you are properly insured.  

Similarly, in Step 6 I recommended you establish some form of emergency fund for those unexpected things that seem to plague us all, like repairing a car, replacing a home appliance, getting a crown for a cracked tooth, or a global pandemic.  I felt this needed to be in place before you sank all of your financial energy and resources towards paying off debts.

Finally, it didn’t make sense to me to focus all of your energy for months or years on debt reduction before making sure you were maximizing all of your employment benefits in Step 7.  Don’t slave away in your job for months or years to pay off debts, only then to realize you were missing out on thousands of dollars of unclaimed  benefits.

Only after these things were taken care of did I feel it would be appropriate to REALLY go after your personal debt.  And that is why it is Step 8 of my recommended steps to reach financial independence.  

With that, let’s discuss the steps I recommend to pay off your personal debt!

Stop Digging the Hole Deeper!

The first thing you have to do is stop going into debt.  Now.  Today.  

Debt is not just a financial problem, it’s a behavioral problem.  In fact, I personally think it is more behavioral than financial.  As credit has become easier and easier to obtain, there has been a shift over the last few decades from buying something when you have saved enough money for it, to buying something whenever you want it and figuring out how to pay for it later.  

In today’s society we seem to have a prevailing attitude of “I deserve this” or “I can afford this” so long as I can make the monthly payments, all the while accruing interest in the background.  The great irony here is we think we are rewarding ourselves with this instant gratification, when in actuality we are significantly hurting our financial futures.  

And I am not holier than thou here.  I know about this because I’ve seen it happen to myself as well over the years.  As I’ve worked to become financially independent, I’ve had to make significant changes in my own financial behaviors, learning more financial discipline.  

So, if you want to get out of debt, you need to start changing your financial behaviors right away.  You can’t keep digging the hole deeper because every dollar of debt you add not only adds to the total debt load, but also means you are paying more interest to your creditors every month.  

Stop buying more than you can afford and live within your means.  In Step 3 you should have completed a detailed analysis of your expenses.  Now is the time (if you haven’t already) to get rid of those things that you can’t afford.  Eliminate the expenses that don’t bring you any significant value in your life.  The more expenses you can eliminate, the more money you can use to pay off debt.

Stop buying things on credit.  If credit cards have been a problem for you, STOP using credit cards.  Use a debit card or use cash.

Stop making new debt purchases.  Now is not the time to buy a new car with an auto loan.  Now is not the time to take out a loan for that kitchen renovation.  Now is not the time to take out a home equity line of credit.

Stop digging the hole deeper.  Period.

How Much Debt Do You Have?

Next, it’s time to get organized.  You need to figure out how much debt you have.  

This could be a bit painful if you’ve been ignoring this aspect of your finances, but you need to be honest with yourself, suck it up, and start adding everything up.

List out ALL the debts you have.  If you completed Step 2 and calculated your net worth, you should already have a list of all of your liabilities.  This includes credit card debt, student loan debt, auto loans, medical bills, money borrowed from family, anything.  Don’t leave anything out, with the exception of your home mortgage, which we will discuss in Step 10.  

There are two important things to note about each debt: the amount and the interest rate.  This will help you determine your strategy to start paying these debts off.  I recommend creating a spreadsheet or some other type of organized list.  

Negotiate, Consolidate, or Refinance High Interest Rate Debts

Before you pick a strategy to start attacking these debts, it is important to look at the respective interest rates and see if any of them are excessively high.  If so, I would recommend taking steps to refinance, consolidate, or negotiate for lower interest rates.  DO NOT SKIP THIS STEP.  A few minutes to hours on the phone or online could save you hundreds, if not thousands, of dollars in the long run as you work to become debt free.

Let’s start with credit cards.  The average credit card these days has an interest rate of about 20%, with many being much higher.  “So what,” you might say, “I get letters in the mail every day with credit card offers that have similar rates.  That’s what everyone pays.”  But let’s stop for a second and think about what that means.  If you carried an average credit card balance of $10,000, every year you would be paying $2,000 in interest alone.  That’s month after month, year after year that you are paying interest.  Let’s think about the opposite of debt: investing.  If someone offered you an investment with a guaranteed 10% return every year, year after year, it would be incredible.  This is exactly what you are doing with your credit card debt . . . except YOU are the one paying interest to someone else, at TWICE the rate!

So instead of just throwing up your hands and paying these outrageously high interest rates, call your credit card companies to see if they are willing to lower the rate.  Tell them you’ve been a loyal customer for a long time, you’ve been on time with your payments (hopefully), and you’d like to request a lower interest rate.  What’s the worst that could happen?  They say no and you’ve lost no ground.  But credit card companies want to keep your business.  So there’s a good chance it will work.  And if it does, it could save you a ton of money.  Back to the above example, if the credit card company dropped your interest rate from 20% to 15%, that would save you $500 a year.  If it took you three years paying other debts before you got to that specific card, that would save you ~$1500, for just a 10 minute phone call.  Now that’s time well spent.  

What about student loans?  Most people have multiple student loans from different sources with varying interest rates.  These interest rates can vary from 3% to 15% based on when the loan was taken out, the amount of the loan, and whether it was a government or private student loan.  If you want to simplify the number of payments you have to make and try to get better loan terms, then you may want to look into consolidating or refinancing your student loans.  The difference between these options is subtle and beyond the scope of this post (it could be an entire blog post itself), but if you want to learn more, here is a great article explaining it at Sofi.com. 

If you can get a lower interest rate on your student loans, especially if you have large balances, this could potentially save you thousands of dollars as you work to pay off all of your debts over time.  However, just like other loans, understand what you are signing up for.  Variable interest rates are usually lower in the beginning, but have the potential to rise over time, so most financial experts recommend refinancing with a fixed interest rate.  Also be wary of just getting a lower monthly payment.  While this may have great appeal in the short term, what is usually happening is the term of the loan is being extended, which means you pay more total over time.  

A word of caution before you jump into consolidating or refinancing student loans.  Be aware that you may no longer be eligible for some government loan forgiveness or repayment plans, such as public service loan forgiveness or income based repayment plans.  If you are interested in any of these types of options, be sure to do your research and consult a financial professional who specializes in student loans before doing something you regret. 

Pick a Strategy

There are two common strategies used to pay off debt: the debt snowball plan and the debt avalanche method.  

The credit for the debt snowball plan typically goes to Dave Ramsey and is quoted by just about every personal finance expert. Here are the basics of the debt snowball plan:

• List all of your debts from smallest to largest, regardless of the interest rate.  
• Make the minimum payments on all of these debts with the exception of the smallest debt.  
• Find every extra dollar you can and throw it at this smallest debt until it is completely paid off.  
• Now move onto the next smallest debt, using all of the money you were paying towards the first debt PLUS the minimum payment you were already making towards the second debt until the second debt is paid off.  
• Continue this pattern until all of the debts are completely paid off.  By following this pattern, the amount you are able to apply towards each successive debt increases, just like a snowball rolling down a hill gaining momentum, thus the name.

What I like about this plan is that it focuses on behavior, not math.  Dave Ramsey argues that you are in debt due to a behavioral problem, not a math problem, and we need to focus on changing behavior to turn things around, and I tend to agree.  He states that we need get some quick wins to get you moving in the right direction and gain momentum.

Opponents of the debt snowball plan argue that it is not the most mathematically efficient way to pay off the debts.  They advocate for what is called the debt avalanche method.  Here are the details of that approach:

• List all of your debts in order by interest rate, from the highest to the lowest, regardless of the amount of the debt.
• Make the minimum payments on all of these debts with the exception of the debt with the highest interest rate.  
• Find every extra dollar you can and throw it at the debt with the highest interest rate until it is completely paid off.  
• Now move onto the next highest interest rate debt, using all of the money you were paying towards the first debt PLUS the minimum payment you were already making towards the second debt until the second debt is paid off.  
• Continue this pattern until all of the debts are completely paid off.  By following this pattern, you are getting rid of the highest interest rate debts first and in the end you will end up paying a smaller total amount than the debt snowball plan.

It’s hard to argue with the math on this.  However, Dave Ramsey likens this to a diet.  Few of us are unlikely to stick to a diet if we do everything right for a month and see little change on the scale.  Similarly, if the debts with higher interest have very large amounts, and it takes many months or even years to pay them off, we are much less likely to stick to the plan.  By getting some quick wins with the debt snowball plan, it builds momentum and confidence, making it more likely for people to continue paying off their debts.  

I think the best thing to do here is just ask yourself what you think would work better for you and then stick to it.

Get to Work!

There is no secret formula here.  Once you have all of the above steps complete and your plan formulated, it’s time to get to work.  Get intense about it.  Find ways to earn extra income so you have more money to pay down the debts.  Find ways to reduce expenses.  The more money you can throw at your debt, the quicker it will disappear.  And once you start eliminating the debts one by one, you will gain momentum.  Every debt you knock out gives you that much more money to pay off the next one.  

Depending on the amount of debt that you have, it may take you many months or years to complete this step on the path to financial independence.  It won’t be easy, but I promise it will be worth it.  The key is to stay motivated.  I found it very helpful to visually track our progress when we were paying off debts.  This could be done with a spreadsheet or even a simple list where you have drawn a line through the debts you have paid off and can envision what you have left.  

And remember why you are doing this.  This takes us back to Step 1, Define Your Why?  Keep you eyes on the prize. 

Conclusion

Debt is something that has plagued nearly all of us at some point in this day and age.  And once you are in debt, it is your constant companion every second of every day.  It slowly suffocates you and blocks the path to financial independence.    

Well I say enough is enough.  It’s time to set yourself free and take your life back!  If you still have debt in your life, make a commitment today to start getting rid of it and become debt free.  Imagine how free you’ll feel without these shackles of debt weighing you down. 

Here are some take home points to consider:

• The first step to getting out of debt is to stop digging the hole deeper.  Make a commitment to yourself to live within your means and only buy those things you can truly afford.  

• It might be painful, but list all of the debts you have, including interest rates, so you know what you’re up against.  

• Don’t fight any more of an uphill battle than you need to.  Ask your credit card companies if they can lower your interest rates.  Consider consolidating or refinancing your student loans.

• Know thyself.  Choose the debt repayment strategy that will work best for you.

• Take the bull by the horns and get after it.  Knock those debts out one at a time.  Every debt you pay off brings you one step closer to Freedom Through FI!

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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