Pay off debt

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Debt entails costs and these interests can be high, try to pay off debt as soon as possible! Before starting to pay off debt, I recommend you first save up a small emergency fund of 1000 euros for small unexpected expenses. 

Step 1 : calculate your net worth

Step 2 : create a budget

Step 3 : pay off debt (excl. mortgage)

Step 4 : create an emergency fund

Step 5 : build a financial plan

Step 6 : invest and “stay the course”

There are 2 types of debt : ‘good‘ debt and ‘bad‘ debt, with an important distinction between these two.

Good debt

Good debt is used to finance purchases that will result in future income/savings or that may increase in value in the future.

The most common good debt is a mortgage loan, this involves real estate, or a loan for energy-saving expenses.  When you take out a student loan you are also indirectly investing in yourself.

Bad debt

What about bad debt? These are debts incurred for purchases whose value will decrease in the future. Try to avoid these debts or pay them off as soon as possible.  When you buy a new car, its value has already decreased after the first day.  It is best to buy a car second-hand and pay cash.

Other examples of bad debt include consumer loans, overdraft on your checking account, credit card debt or borrowing for a new cell phone.

Good debt is used to finance purchases that will result in future income/savings or that may increase in value in the future.

There are 2 ways to pay off bad debt on an accelerated basis.

1. “Debt snowball” method

The “debt snowball” became popular through Dave Ramsey. Using this method, you make a list of your debts to be paid off from small to large, no matter what interest rate.  First, you start paying the minimum repayment for each debt.  Then, in addition to the minimum repayment, you pay off the smallest debt first. When this first debt is paid off, you use the minimum repayment of this first debt to pay off the second debt faster. This creates a snowball effect, like a snowball rolling down a mountain and getting bigger and bigger.

Using the snowball method, you will quickly see the first results and motivates you the most to pay off your debts.

2. “Debt avalanche” method

Using this method, you also make a list of the debts to be repaid, but this time the debt with the largest interest rate first and the debt with the smallest interest rate last.  You also start paying the minimum repayment for each debt.  Then you pay off the debt with the highest interest rate first and when this debt is paid off you pay off the debt with the second highest interest rate, and so on.

The avalanche method is mathematically better, since you faster pay off debt with high interest. 

Let me show you an example.

Let’s say you have 2 outstanding debts :

Debt 1 : 1200 euros debt, minimum monthly payment of 200 euros, 5% interest

Debt 2 : 3000 euros debt, minimum monthly payment of 300 euros, 7% interest

You received a windfall of 2500 euros and use it to pay off some of your debts.  

First pay off the minimum monthly payments : 200 + 300 = 500 euros.  

In the case of the “snowball” method, you will use the remaining 2000 euros as follows :

  1. pay off debt 1 in full : 1000 euros
  2. pay off part of debt 2 : 1000 euros

Debt 1 is now fully repaid, while debt 2 still has an outstanding balance of 1700 euros.

If you use the “avalanche” method, you will use these 2000 euros to pay off the following debts :

  1. pay off part of debt 2 : 2000 euros

You still have an outstanding balance of 1000 euros for debt 1 and an outstanding balance of 700 euros for debt 2.  

Which is the best method?

Which method is best to choose for paying off debt?  Financially, we tend to choose the “avalanche” method because you are paying off the most interest.  But don’t underestimate the psychological effect of the “snowball” method! If you think the psychological incentive of paying off a smaller debt sooner will help you pay off your debts in full, then you best choose the “snowball” method.

There is also an additional benefit of paying off debt early: you have a guaranteed return, namely the interest on the loan.

Don’t hesitate to contact the lender to set up an installment plan.

Once you have paid off your (bad) debt, the next step is to create an emergency fund.

This info is for informational, educational and entertainment purposes only, and does not constitute financial, accounting, or legal advice. Please do your own research (disclaimer).

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