Crushing Debt: A Guide to Paying Off Loans and Building Wealth

Interest rates have risen rapidly in the last 18 months. As fixed-rate mortgages expire, many of us will feel the pinch. In this situation, many people have pushed paying off their debt to the top of their priority list. This week, I’d like to look at some ways you can accelerate your debt repayment.

Debt Avalanche vs. Snowball Debt

Debt Snowball or Debt Avalanche is a popular strategy for paying off debt. The only difference between them is the order in which you attack your debts. These are only for people with multiple debts. For example, a mortgage loan, credit card debt, and possibly a car loan.

The Debt Snowball method involves making a list of your debts and ordering them from the lowest to the highest balance.

Make the minimum payments on each debt, then use your surplus to pay off the smallest debt, the one at the top of the list.

After paying off the first debt completely, you will have the money to pay the second debt. The process is repeated until you have only one debt left, which will likely be the mortgage of your home. All the money that would normally go to paying off credit card debts and other small loans can now go toward this loan.

This approach has two advantages. It’s a great feeling to know you are free of debts and that they have been paid. This approach can lead to quick victories. You might be able to clear the smallest loans in a matter of months. This can be a great way to boost your confidence and help you to continue making progress.

The Debt Avalanche method involves making a list of your debts. However, you can now order them from the highest to the lowest interest rates. To do this correctly, you will need to adjust the interest costs of any loans that are tax-deductible so that they reflect the price after tax.

Snowball is also a repayment method. Spend all of your time and energy paying off your first debt. Once that is done, you can move on to the next.

Although the Debt Avalanche method is mathematically superior, many people are more successful with the Debt Snowball technique due to its psychological advantages.

Principal and Interest vs Interest only

The structure of most loans is Principal and Interest. With each repayment, you pay off both the Interest and principal debt so that the loan value decreases over time. Some loans only charge Interest. This is most common with investment property loans. However, if you pay only the minimum amount on your credit card, then it’s close to being interest-only.

Find out what your repayments would be if you changed them from interest-only to principal and Interest. You will find that principal and interest loans have a lower interest rate, so your monthly or weekly repayments may not be much different. This change will save you a lot of money in the long run and help you to build financial security.

Consolidation of debt

Debt consolidation is a great way to consolidate your debts. It would apply to someone who has a personal loan and a mortgage, as well as a loan for furniture or a car. You could lower the cost of debt in this situation by consolidating all your loans into one mortgage. This new loan, which is secured by your home, would have a lower interest rate than unsecured debt.

It is important to continue paying off your loan for the same amount of time. It would seem obvious to refinance a Harvey Norman loan of $2,000 over two years with a 15% rate. This can be misleading.

You will pay $5,688 in Interest if you take 30 years to repay that mortgage! If you had stayed with the two-year original loan, the cost would have been almost tripled. You would have had to pay $567 in Interest, which is one-tenth of the original loan.

The key to making debt consolidation effective is to maintain your current repayment level, if possible.

Refinancing

This past year, mortgage brokers were kept busy refinancing loans with fixed rates that had expired. The competition amongst lenders was fierce, though I’ve heard it has slowed down recently. It’s still worth looking into refinancing your loan to get a better rate. Talk to a broker, or do some internet searching yourself. Then, talk to your bank to see if they can match any offer you find. It might be worth switching banks if they cannot. Be sure to understand all costs involved with the switch.

Offset accounts

Offset accounts can be a great thing. Offset accounts are fantastic. If you have a mortgage, the offset account will likely offer the best return on your savings.

You may be able to use an offset account. Could you use your emergency fund as an offset account? What about your account for bills? You could use another account to save money for holidays. These will all reduce your interest costs on the loan, and each repayment will reduce that principal further.

Motivation

It’s usually more fun to accumulate debt than pay it off. Unfortunately, just like after a night out in town, the length of the hangover is far longer than the time taken to cause the damage.

It can be difficult to stay motivated and stick with your plan for debt reduction. Set yourself goals and recognize this right from the start. You may want to reduce your debts by a certain amount or, if you are using the Debt Snowball method, get rid of an old debt. Celebrate when you achieve these milestones. It would be best if you did not go into debt to celebrate, but you can certainly find ways to reward yourself.

You could also use a tally to motivate yourself. Keep a running total on your fridge or wardrobe door, and mark off the numbers as you pay down the debt. It’s satisfying to cross out something and know that it’s gone physically.

Time to downsize?

If you are really struggling with debt, it may be time to re-evaluate your current situation. It’s stressful to feel like you can’t keep your head above the water, both for you and your partner. Financial stress is a major cause of divorce.

Consider whether you can afford to live where you currently are. It’s not easy, I know. But you may regret it in a few short years.

Debt and wealth creation: Tax-deductible debt

Not all debts are created equal. Tax deductions are available for debt used to buy assets that generate income. It would be best if you accounted for this when calculating your debt reduction plan. Calculate your marginal tax rate and reduce the interest costs to reflect what you are paying. You can bet that an investment loan that has a headline rate of Interest that is half a percentage higher than your mortgage loan will actually cost you less once you take into account the tax deductions.

Recently, I did some calculations for a client who had a 7.75% investment loan. After-tax and after allowing dividend income from investments to be taken into account, we found that a growth rate of less than 1% annually was all that was needed for the strategy to stay viable. Tax-deductible debts are more affordable than you think.

So, I hope this has given you some things to think about. Debt is necessary to build wealth. In Australia, it’s nearly impossible to purchase a home without borrowing money. Most wealth-creation strategies also require debt to achieve their goals. The interest rates are high, but not by historical standards. Just a painful adjustment to make. If debt is causing stress, you should take action to put yourself in a long-term sustainable position.