In the first installment of the “3 B’s,” we looked at how to build and manage a forward-looking budget. Today, let’s take a look at the second component of saving, “beating debt.”
Before anything else, we must first distinguish “good debt” versus “bad debt.”
Good debt has four characteristics:
- Low interest rates.
- Affordable payments.
- A reasonable balance relative to assets.
- Investment-like. A debt that results in a qualitative and/or quantitative improvement to one’s life (mortgages, student loans, and car loans).
Bad debt, on the other hand, is unhealthy and counterproductive to your long-term financial well-being. Bad debt is any debt that fails one of the four “good debt” criteria. Typically, bad debt feeds our baser instincts, and is characterized by high interest, unaffordable payments, and high balances.
So, how do we get rid of it?
Debt elimination. Eliminating debt can be an arduous, extended, emotionally draining process that requires planning and self-discipline. Unfortunately, many people who have significant debt problems have already demonstrated that they are not good planners and have lacked self-discipline. If this is your case, I would strongly encourage you to consider some kind of a coach through your debt elimination journey.
There are three techniques commonly employed to eliminate debt. These are:
- Refinance and/or consolidate debt.
- Pay off the highest interest rates first.
- Payoff the smallest debts first.
Consolidating and refinancing debt is often the most effective way to eliminate it. However, depending on the excessive debt balances or poor credit history of the borrower, it may or may not be a possibility, in which case you have other options. (If you do choose this route, however, I highly recommend consolidating and refinancing debt with reputable banking institutions.)
If consolidation is not going to work for you, you may be able to save money on interest through the length of your loans by paying off the loans with the highest interest rates first and, as each loan is paid off, redirecting the available dollars to the lower interest loans. Obviously, this technique only works if there are dollars available above the total required minimum payments.
Another option is to start by paying off the smallest debts first, regardless of their interest rate, and then redirecting available dollars to the larger loans as the smaller loans are paid. While this technique will result in you paying more in total interest through the life of the loan, many people have found it to be emotionally satisfying to make some quick progress up front.
Credit score. Check your credit report at least once per year at one of the three credit reporting agencies: Equifax, Experian, or TransUnion. You can check it for free annually at www.annualcreditreport.com.
Remember: like smoking, bad credit is easier to avoid than it is to recover from.
Next, in our final installment of “The three B’s of saving,” we’ll discuss my favorite topic, “building savings.”