Whether your goal is being debt free or just free of bad debt, use the process below and commit to a better financial future for yourself and your loved ones.
I read a shocking statistic the other day. While only about 27% of Americans carry credit card debt, more than half of lower-income households carry revolving debt. Worse still is that debt payments account for between 47% and 56% of their monthly income. We talk a lot about bad debt and being debt free on the blog but it seems and unreachable goal for many people.
More than any other factor contributing to poverty, bad debt can be a shackle on your life and the lives of your children. I have been there and my son is my reason for being vigilantly debt free and the reason I follow the six-steps below to remain that way.
Bad Debt can be a Generational Oppressor
America was built on the dream of pulling yourself up by the bootstraps and being financially successful. Billionaires like Larry Ellison and Oprah Winfrey prove it can be done but the truth is that where you end up usually looks a lot like where you started in life.
I know the story though I’ve busted my butt to change the ending. My mom filed bankruptcy twice before I was in my teens and she regularly had to work two or even three jobs to make ends meet. Between a mortgage payment, credit cards and high-interest loans used to get us to the next paycheck the amount of bad debt was just too much. If not for a scholarship from the Marine Corps to attend college, higher education would have been a pipe dream and I would probably be stuck in that same cycle of debt myself.
Don’t get me wrong. There are things that money can’t buy and we had all we needed. I always felt loved and we always had a roof over our heads but debt really made things difficult.
Bad debt is truly a generational oppressor. The same studies where I found the above statistics also show that only 37% of those without a high school diploma are able to save money regularly. They are stuck in a cycle of bad debt, living paycheck to paycheck and most of their kids will never know anything else.
While my son will probably never rub elbows with the Rockefellers or have everything laid out for him, I’ve made a commitment to breaking that cycle of debt oppression.
Good Debt, Bad Debt and being debt free
The debt purists are already annoyed by the article and my constant use of “bad debt” instead of just debt. The fact is that there’s a difference between good debt and bad debt even though it is not talked about much on personal finance blogs. I’ve read too many blogs that scream the mantra that you should reach to be completely debt free.
Debt is like any tool and can be used to help us make great things. It can be used to put a roof over your heads and to get an education that helps you break your own reliance on credit. The problem is that bad debt looks a lot like good debt. Like any tool, used incorrectly can result in smashed fingers or worse.
Bad debt can also come from sources of good debt. Taking out a mortgage for a house is fine until you start thinking about the maximum size of house you can get with an available line of credit. How many House Hunters shows have you watched where the couple is approved for a loan of up to $300,000 so the real estate agent pushes them to houses at that price or even higher? Debt should be used for what you need, not for the McMansion you want. There’s also nothing wrong with using a credit card and even carrying a balance. The problem is when you think of your available credit balance as money to spend on things you don’t really need.
Debt used to buy something you truly need or that will appreciate in value is likely to be good debt. Be careful to not justify your use of debt by reasoning that it’s good debt but don’t completely avoid debt either.
My Process for Being Free of Bad Debt
My own process for being debt free has worked pretty well and I check in on it often to keep me on the right path. Before you can tackle your bad debt, it helps to know where you’re starting in terms of your credit and how much debt might be weighing you down. I use TransUnion, one of the three credit report companies, to check my credit report and monitor for changes in my credit score.
1) Define Bad Debt and Don’t Stray
Because it can be so easy to justify overusing debt, you need to start with a commitment to not using bad debt.
- Ask any real estate agent how much house you can afford and they’ll start with how much money you can get from a mortgage. Don’t start there! Ask yourself how many bedrooms and bathrooms you need for your family. Understand that you’ll probably spend most of your time in a few rooms so be critical on how much space you really need in the rooms you won’t be using much.
- Credit cards are a killer. The average person with a balance has more than $15,000 in debt at a rate of 13%. That means they are spending nearly $2,000 on interest every year. I use two credit cards. One is only for absolute emergencies. I’ve only used it rarely when we had a family emergency and I didn’t have enough cash in my emergency fund. The other credit card is for normal daily purchases but gets paid off every month and earns cash back for my son’s 529 college fund.
2) Budgets are something everyone talks about but nobody actually does. Even if they do start a budget, many people end up following it for less than a month.
- Instead of starting your budget with your expenses, only to find that you’ve got no money to save at the end of the month, start by budgeting how much you want to save. You should be saving at least 5% of your income but a better goal would be 10% or more. Take this amount out first and then budget out your most important expenses. This will help make sure you always have something to save and can help with a little financial discipline if you have to cut some of the less important expenses.
- Try to follow your budget for at least three months. Keep track of your expenses by putting all receipts in one place. If you can do it for three months, you’ll have built some good habits that will seem natural going forward.
3) Earning a little extra may be a quick way to get out on top of your bad debt or a way towards longer-term goals.
- Technical skills and workers were the first to go online but just about anyone can find freelancing jobs online these days. Check out websites like like our previous post on how to make money freelancing for all your options.
- If you have a particular need whether it be a medical expense or money for education, you might want to consider crowdfunding. I run another website at Crowd101.com as an informational guide for crowdfunding campaigns. Beyond business startups and social causes, I’ve seen people raise money for all kinds of personal expenses. If your story is compelling and you can show a genuine need, it can be a lot of money to pay off bad debt and money you don’t have to pay back.
- Bought more house than you need? AirBnB is a relatively new site that lets you rent out rooms to short-term or long-term renters. A renter rating system and other feedback helps to get to know the renter before you meet them and you’re never under an obligation to let someone stay.
4) Consolidate through Peer Lending – Online lending through sites like Lending Club and Avant have gone from the alternative to mainstream lending over the past year. Check out my peer lending sites review for a comparison of the largest peer lending sites.
- Like credit card debt, peer loans should not be used for conspicuous consumption but they can help build your credit and pay off high-interest credit card loans. Rates can be as low as 6.7% and you can borrow up to $35,000
- Since peer loans are for a fixed-rate and a fixed amount of time, you have a clear path to being debt free unlike credit card debt that seems to continuously pile higher. A little known bonus is that peer loans are considered installment loans by the credit score agencies. The credit score agencies negatively rate your credit card debt, classified as revolving debt, more because it has no maturity. Consolidating your credit card bills with a peer loan can help increase your credit score. Check out an earlier article on other credit score factors and how to improve your score before applying for a loan.
5) Saving all your money will do you no good if you lose it all in the next market crash. Smartly investing your money in a diversified portfolio is key to having the money you need in the future.
- There’s no rule that applies to everyone but I would put no more than 50% of your wealth into stocks. Anyone investing over the last couple of decades will tell you that it can all vanish in the blink of an eye. Spread your wealth between stocks, bonds, real estate and alternative investments like peer loans.
- Anyone that guarantees you a certain rate of return is probably planning on stealing your money. The only investments that can guarantee a return are treasury bonds and some annuity insurance products. Aim for a modest return of about 5% to 10% for your portfolio and be cautious of investments that seem too good to be true.
- Resist the temptation to check the value of your investments more than once every few months. Following the financial pundits on TV or watching the short-term fluctuations in investments too closely will only lead to panic selling when prices are low or euphoric buying when prices are high.
6) Enjoy Life – Being debt free or free of bad debt does not mean a lifetime of sacrifice and hardship. Besides understanding the importance of breaking the cycle of debt oppression, you also need to understand that it is a lifelong process. Taking on three jobs and sacrificing all your time will just leave you burned out and lonely. Make sure you set realistic goals that can be kept while still enjoying time with your family and getting you closer to financial well-being and debt free.