Debt is not a bad thing. Sometimes debt gets a bad rap, but in reality, almost everyone has some form of debt. In fact, sometimes taking on debt is necessary to keep your financial journey moving. Yes, sometimes debt can become an issue, but it all depends on what types of debt you take on and how you handle it.
Not all debt is created equally. There is Good Debt and Bad Debt.
Step 3 of the Guide to Building Generational wealth focuses on paying off Bad Debt. Note that this doesn’t mean that you should plan to pay off all debt, just the bad stuff.
Typically, you should move to Step 3 immediately after completing Step 2 & building your Emergency Fund. However, in certain cases, it makes sense to work on Step 2 and Step 3 simultaneously. For example, if your level of debt is severe and growing at a high interest rate, then you should start paying that down immediately. You don’t want that debt to compound on you too much while you are working on your Emergency Fund. This does not mean that you should completely neglect your Emergency Fund savings. If you haven’t made any progress on your Emergency Fund, then you will have to take out more debt to meet your next emergency expense and have thus restarted the cycle.
It's important to pay off Bad Debt for several reasons. First, it is important to prevent high interest rates from causing your debt to compound over time. Typically, in the world of finance, we think of compounding interest as a good thing in the context of investments. Compounding interest can really work against you in the context of debt. Second, it is important to eliminate bad debt to create financial freedom. Bad Debt is the kind of thing that can trickle down to your health and wellness because of the stress it can create. Thirdly, you typically need to eliminate Bad Debt in order to qualify for Good Debt. For example, paying off Bad Debt like high interest credit card debt can increase your credit score and therefore improve your chances of qualifying for Good Debt like a mortgage.
Identifying Bad Debt
It’s not always easy to identify which of your debts are “good” and which are “bad.” The difference isn’t always black and white, but you can identify a debt as “good” or “bad” by answering the following two questions about each debt.
1. Who do I owe?
2. How much are they charging me?
Start by identifying who you owe. If the answer is the IRS, then this is instantly a Bad Debt. The IRS is not a lenient lender and can seize assets such as wages, bank accounts, Social Security benefits, and retirement income. The IRS also may seize your property (including your car, boat, or real estate) and sell the property to satisfy the tax debt. If instead, you owe a financial institution, the terms of the loan will determine if you have a “good” or “bad” debt.
Next, identify how much the lender is charging you. Typically, you want to look at what level of interest the lender is charging you, but you should also be wary of any one-time loan processing fees. If the lender is charging you a lot, either through loan processing fees or interest, the debt is more likely to be considered a Bad Debt. If instead, the processing fees and interest charges are low, the debt is more likely to be considered a Good Debt.
To determine how “bad” or “good” a debt is, use what I call: “The Law of Interest Rates.” This law tells us that we should put our money toward vehicles with the highest interest rates, whether that be an investment vehicle or a debt vehicle. In the long run, this will result in the highest individual net worth. The logic is simple. If you put your money into an investment vehicle it will grow at the rate of interest. If you put your money into a debt vehicle it will stop growing at the rate of interest. One example where it makes more sense to save than pay off debt is when you can earn higher interest from your investments than you can save by paying down your debt. For example, if your average annual investment return is 8% for your retirement savings and your mortgage’s interest rate is 3%, it makes more sense to save into your retirement savings than to pay off your mortgage. Alternatively, an example of where it makes more sense to pay off debt than save is when your debt has a higher interest rate than the return you expect on your investment. For example, if your credit card has an interest rate of 20% and your average annual investment return is 8% in your retirement savings, it makes more sense to pay off your debt than it does to save into your retirement savings.
As a general rule of thumb, I typically use 7% as the cutoff between Good Debt and Bad Debt. This cutoff number is different for everyone, but I use 7% because that is approximately equal to the worst 20-year average performance for the S&P500. If your debt has an interest rate above 7%, I would instantly categorize this as a Bad Debt because there aren’t any investment alternatives where you could reliably outpace that interest rate. If your debt has an interest rate below 7%, I would label this as a Good Debt. This doesn’t mean that you should never pay off this debt, and of course you should always make minimum payments. This Good Debt label does mean that it is outside of the scope of Step 3. We will discuss paying off Good Debt in Steps 4 and 5.
The distinction between Good Debt and Bad Debt depends on the specific terms of each debt, but here is very generalized table to help you identify the different types of debt:
Pay Down Your Bad Debt
Once you’ve identified the Bad Debt in your life, the next step is putting together a plan to get rid of that Bad Debt. The two essential concepts to guide you through creating this plan are the “Law of Interest Rates” and the “Set It and Forget It,” concepts.
First, utilize the “Law of Interest Rates” to help you prioritize your Bad Debts. The debt with the highest interest rate should be highest on the priority list. Then, take a look at your Personal Cash Flow Statement to calculate your debt repayment budget.
Next, determine what the minimum monthly payment for all of your loans is. Subtract that number from your debt repayment budget, and this should leave you with the “extra” money that you can allocate toward debt each month. Take advantage of the “set it and forget it” concept by setting up automatic payments for the “extra” monthly amount. Start by setting up automatic payments going into the debt with the highest interest rate.
Once this debt is completely paid off, move the “extra” automatic payments to the debt with the second highest interest rate. Continue working down the line until all of your bad debts are paid off.
I would also recommend setting up automatic payments for loan minimums, so you can make sure you at least meet minimum payment requirements even if you are focusing on paying down another debt.
Emergency Options
Despite our best efforts, sometimes debt can spiral out of control. If we take on too much debt and don’t earn enough to pay it back, we can work ourselves into some tricky situations.
If your debt situation feels beyond repair, there are a few emergency options to know about:
0% APR Credit Cards
If you find yourself with lots of high interest debt that will take you some time to pay back, consider applying for a 0% APR Credit Card. This is a credit card that charges no interest for a certain introductory period of time (i.e. 6 months – 2 years).
Transferring your balance to a 0% APR Credit Card can buy you time to make more progress on your debt repayment while slowing down the growth of what you owe.
Note, you need to have a good credit score for this to be an option. In addition, applying for a new credit card could hurt your credit score and typically there will be a charge for transferring your balance from another card.
Debt Consolidation
Debt consolidation may be an option if you find yourself with multiple forms of high interest debt. Typically, debt consolidation will allow you to transfer all of your debt balances to one financial institution. This institution will typically bring your interest rate down to a more manageable level, but also will put you on a strict repayment plan.
Bankruptcy
If you can’t qualify for a 0% APR Credit Card or debt consolidation, your last option is to file for bankruptcy. Bankruptcy is a legal process for getting relief from debts you cannot repay.
A Chapter 7 Bankruptcy will sell your non-exempt assets to pay your creditors.
A Chapter 13 Bankruptcy will allow you to keep the assets but must repay your debts over a specified period.
Bankruptcy can do severe damage to your credit score and should be considered a last resort.
Manage Your Mindset Around Debt
Debt has a really bad reputation and rightfully so. If not managed appropriately, it can quickly derail your financial plan and become a crippling burden. However, for most, taking on debt is necessary in order to make progress on your financial journey. In our current society, most are told that you need a college degree in order to get a good paying job. However, most people cannot afford the full cost of college at 18 years old, so many have to take on Student Loans. Similarly, in our society we are taught to strive to buy a house. However, most people don’t have several hundred thousand dollars lying around to buy a home, so we are forced to take out mortgages. These examples just show that debt itself is not always a bad thing, and in certain cases, some Good Debt is necessary to keep our financial journeys moving forward.
There is absolutely no shame in having debt, even Bad Debt, as long as you have a plan. If we look at the general arc of our lives, we often need to take on debt in the early years in order to grow. If we continue to grow financially over time and increase our earnings, we eventually hit a point where we are more easily able to pay off our debts.
The chart below shows a typical journey of someone leaving college with loans and a negative net worth. Once this person begins their career, they typically earn more and more each year. Eventually they hit a point where they are more easily able to pay off debts and start to build a positive net worth.
It's important to manage our debt responsibly, but if you feel like you are the person at the beginning of this graph with lots of debt and not enough income, there is hope.
Building Generational Wealth is a long game. Think of yourself like your own start-up business. Any successful start-up has to invest in itself to grow and often will take years before it becomes profitable. Your financial life might follow the same journey, so don’t assume that just because you have lots of debt, that you have done something wrong. You are probably just at an early point in your financial journey.
For Step 3, you don’t have to pay off all of your debts, but you do need to have a plan in place to eliminate the Bad Debt. This is a key step toward building Generational Wealth and will allow you to move to Step 4: Financial Goals.
This blog post is a rough draft for Chapter 3 of 10 for my Step-by-Step Guide for Building Generational Wealth. For now, each step will be in the form of a monthly blog post. I really hope to get your feedback and thoughts. After finishing the step-by-step guide, I plan to revisit each blog post, add detail, implement changes based off of your feedback and thoughts, and then publish the guide into a book. While creating a book is a daunting task, the impact that I think this book will have on my community continues to motivate me.