If your finances are a bit out of control, there are many things you can do to gain back stability. Paying off debt is an essential part of getting your financial life in order.
While it may be overwhelming at first, do your research and take it one step at a time. There are many resources out there, such as the best personal finance blogs that can help you get started.
Debt can be crippling to your finances and create a sense of weight on your shoulders that never seems to go away. Not only does debt hinder you from saving for your future, but it inhibits you from living with the freedom you deserve.
This post was written in partnership with Sam from How to Fire and The Money Mix
Think about what you’d be able to accomplish if you didn’t have the obligation of handing over your paycheck to debt payments every month. You’d have the financial freedom to pay yourself first and live your life the way that you want. That could include not living paycheck-to-paycheck, saving for retirement, funding family vacations, working in a job that you love, or just not worrying about how much money is in your bank account.
Now, you may think that paying off debt is as simple as throwing as much cash at your loans as possible, and you’d be partially right. However, there are many other factors to paying off debt that you may not have considered or may not even know about.
With that in mind, here are six things you didn’t know about paying off debt.
6 Things You Didn’t Know About Paying Off Debt
1. Paying Off Debt Will Help You Retire Early
Your income is the most valuable wealth-building tool that you have. When you work on paying off debt, you are enabling your income to be used for a more fulfilling purpose.
You can put your income into savings rather than using it to pay bills. That is highly effective if you want to retire early, and even more so if you start saving sooner rather than later. This gives the power of compound interest the ability to work its magic over time.
When planning for financial independence (FI) and early retirement, you need to calculate your savings rate, FI number, and years to FI. That is an easy thing to do using a FIRE Calculator, but your work doesn’t stop there.
You need to evaluate your current financial standing, make a plan, and follow-through. When it comes to getting control of your finances, the first step to making any progress is paying off debt in most situations. Paying off debt could be the first step towards reaching FIRE.
2. You’ll Create Job Flexibility
How often do you hear people say, “I hate my job?” Money is typically the driving force when it comes to staying in a job you hate and away from a job you could love. Other times, it stands in the way of pursuing a passion, entrepreneurship, or being a stay-at-home parent.
Paying off debt is a great way to free up money in your budget to create more flexibility when it comes to trading your time for money. That is because you will have fewer monetary obligations to fulfill every month.
Reducing the number of bills you pay every month could allow you the wiggle room needed to make a financially-safe transition. Whether you want jobs where you work alone or not to work at all, taking the pressure of debt off your shoulders can open up many doors for you and your family.
The debt-free life is excellent, isn’t it?
3. Your Credit Score Might Tank or Disappear
You might find yourself panicking and asking, “why did my credit score drop after paying off debt?” It’s supposed to help you, not hurt you. Unfortunately, it might not be the case in the short-term.
The two main factors that could affect your credit score while paying off debt are:
- Credit utilization – measures your credit balance versus the number of credit lenders say you can have. It can be affected when you pay off debt from a low balance account, but the rest of your cards are maxed out.
- Credit mix – refers to the type of debts you carry. In other words, a good credit score would have a variety of debt: mortgage, auto loan, credit cards, among others. When you pay off one type of debt, especially if it was on a set repayment cycle, it can negatively affect your credit.
Don’t worry, though, the amount of good you are doing for yourself far outweighs a number that the credit bureaus label you with. It’s very likely that it will crawl back up as time goes on so that you have a good credit score in the long-term.
Paying off debt is an essential part of getting your financial life together, so don’t let a decrease in credit score deter you or stop you in your tracks. Keep going! To mitigate any hard-hits to your credit score, continue making on-time payments, and balancing your utilization rate. You can also consider paying off debt with high-interest rates first, like personal loans and credit cards.
If you pay off all your debt, it might even disappear altogether. The challenges of that are for another post, though.
4. More Money Will Appear in Your Budget
So, you may already know how to budget with debt, but have you thought about budgeting without it? You might be so excited about paying off debt that you haven’t had time to consider the opportunities that await.
The money that you have been earmarking for debt all this time is now able to be allocated elsewhere. While this can be tempting, don’t fall for lifestyle creep!
This is not your chance to upgrade your house or car or increase any other spending habits. Use this instead as a prime opportunity to invest in yourself by making smart financial choices.
Here are great examples of what you can do with the extra money that’s burning a hole in your pocket:
- Build up an emergency fund
- Start or increase retirement contributions (IRAs and 401ks are an excellent place to start.)
- Save for college expenses in a 529
- Make a sinking fund for a vacation (utilize travel rewards to decrease your costs)
- Invest in real estate, whether actively or through a company like DiversyFund
- Start a business
When you use money wisely, it will help you to build wealth over time for yourself and your family.
5. Debt Strategies Affect Your Total Costs
If you’ve heard of Dave Ramsey, you’re probably familiar with the debt snowball and debt avalanche methods of paying off debt. While he believes that the debt snowball method is the only way to pay off debt since it increases motivation, I’m here to tell you to think again.
When you’re paying off debt, you need to go about it the right way. That involves thinking about how your debt payoff strategy will affect your total cost of debt. The financially savvy way of paying off debt is the debt avalanche method.
If you don’t already know how to apply this method to your finances, follow these steps:
- Write out all your debts (auto loans, student loans, credit card debt, etc.)
- Place them in order starting with the highest interest rate first until your lowest interest rate debt.
- Pay the debts off in this order.
The idea here is that you will save money on the interest by paying off your highest interest rate debt first and then moving on to the next highest, and so on.
You could potentially save thousands by implementing this strategy alone.
If you’re just starting your debt payoff journey, you probably didn’t know this.
Dave Ramsey thinks that starting with your smallest debt amount and moving through until you hit your largest debt amount is the right way to go (aka debt snowball method). However, anyone who can do simple math can see that this will cost you big time.
6. Debt Gets Sold for Pennies on the Dollar
Did you know that some debt is sold for pennies on the dollar?
Allowing debts to be purchased by debt buyers is one way that companies try to recoup the money that they lent you. So, make sure to vet whoever contacts you about existing debts, but don’t be surprised if your debt is now owned by someone else. This is especially relevant to those with credit card debt.
These debt buyers are more privy to high-risk investments, so they buy your debt for a fraction of what you owe. If you pay back a debt of $10,000 that they only paid $1,000 for, they collect an incredibly high return.
While this may seem like an incredibly narrow-minded business, some good has come from it. Companies like RIP Medical Debt accept donations to use for the same purpose. The difference? They buy medical debt for pennies on the dollar, but turn around and forgive it.
Can you imagine the relief that individuals and families feel from that? As of this post, the company has helped eradicate over $1 billion worth of debt!
Work on Paying Off Debt in 2020
As you can see, there are many benefits to paying off debt 一 from something as seemingly inconceivable as financial freedom to something as simple as more money in your bank account.
However, it’s essential to consider the other factors that will affect your debt-free journey.
Overall, continue making smart money moves in 2020 by paying off your debt. You’ll thank yourself later as you unlock the ability to shape your own life.