Debt – It Costs A LOT More Than You Think

Paying off debt – or avoiding it – can save tons of money.  Even better is investing the money you would have been spending on monthly debt payments instead.  This post will illustrate how debt works against you, give an example of how avoiding $10,000 of credit card debt and investing those monthly payments instead could make you over $200,000 richer, and provide a simple tool you can use to see how much money you can save by paying off debt as fast as possible and how much more you can save by investing that money instead.  We’ll also leave you with simple, powerful steps you can take to actually pay off your debt.

How Debt Works Against You

***insert debt video here***

Imagine you are on a really long treadmill (like one of those moving walkways at the airport, walking in the opposite direction it’s moving). You walking is like you earning money – it moves you forward.  The long treadmill is like your expenses, taking you backwards.

If you only spend what you earn, you will avoid going into debt, but you also won’t save any money either.  It’s basically like walking in place on a treadmill – you don’t actually get anywhere.  But since you’re also not building up any savings, if you pause for a second or stumble (i.e. lose a job) or the treadmill increases speed (unexpected expenses), you’re going to move backwards (take on debt).

Another way to take on debt is by “living beyond your means” or spending more than you earn.  You may still be earning income, but the treadmill is moving faster than you are walking (earning), so you’re actually moving backwards. 

Once you take on debt, even if you maintain the same level of spending, your expenses actually increase, since you also now need to make loan payments.  In other words, once you have debt, even though you’re not spending more money on “things,” the speed of the treadmill still increases, pushing you backwards a little faster, and leaving you more in debt.  The more debt you take on, the greater your loan payments and the faster the treadmill works against you.  This forces you to work harder and harder just to keep up, otherwise you move backwards faster and faster.

In order to pay off debt, you need to walk/run faster than the treadmill of expenses and loan payments are moving against you, so you can start moving forward.  There are two ways to do this – you can either work harder and earn more money (walk/run faster), or cut your spending (slow the treadmill down).  Ideally, it would be both.  While not everyone can earn more money quickly, most of us can find ways to cut spending and save money starting right now, so we’ll focus on the cutting expenses side.

It will be hard at first.  Cutting spending to pay off debt will only slow the treadmill down slightly at first (more on why below).  But the faster you pay off your debt and the more you pay off, the faster and the more the treadmill slows down, until eventually you get back to your normal pace again and you’re no longer moving backwards. 

While this treadmill really sucks when it’s working against you (you’ll see in the next post on investing), it’s extremely powerful when it’s working for you.  Unlike debt which speeds the treadmill up, investing slows it down for you more and more until it eventually stops, and actually starts pushing you forwards faster and faster.  At that point, even if you decide to stop working, you’re still getting richer and richer.

Avoiding $9,333 of Credit Card Debt and Investing Monthly Payments Instead Could Make You $200,000 Richer

In 2018, the average household with credit card debt had a balance of $9,333.  About 37% of households have credit card debt (from not paying their balance in full every month).  If you have it, you’re not alone.  But don’t let America’s debt culture fool you, your debt is an emergency that is probably costing you more than you think and should be paid off ASAP!

The average interest rate charged by credit cards (if you don’t pay off your balance in full each month) is around 20%.  In addition, if you only pay the minimum payment each month, it can take you up to 30 years to pay off your balance.  Credit card companies love this, since it gives them tons of additional money in the form of interest – at your expense.

Let’s take a look at an example.  We’ll use credit card debt, but the same can apply to car loans, payday loans, etc.  Let’s assume we went big this year and took on $9,333 of credit card debt to pay for a vacation, new clothes, eating out, etc. – after all, you worked hard this year and marketing companies want you to know that you’ve earned the right to “treat yourself.”  In addition, our credit card offers a minimum payment option, which is only $156/month.  So we got all these wonderful things and only pay a small amount each month – sounds great, right?

Not if you follow the intentionally confusing fine print!  In this scenario, you be paying that “small monthly amount” for 360 months (30 years). And, in addition to paying back the $9,333, you’ll also spend an extra $46,811 in interest.  So what should you do?

The best option would be to avoid taking on that debt to begin with!  If you invested* the equivalent of your monthly payment ($156/month) instead, you’d have $190,262 in 30 years.  In addition, you’d have avoided throwing away that $46,811 in interest payments to credit card companies, making you $237,073 richer.  Talk about treating yourself!

What if it’s too late and you already have credit card debt?  The tip below can help you save money and pay back your debt as fast as possible!  The faster you pay it off, the less money you will waste.  Take a look at the two images below.  Notice how in the scenario where you take 30 years to pay off your debt, almost all of your initial payments are wasted on paying interest (look at all that red!), not going towards principal (part that goes towards actually paying off the loan, in blue)?  If you can pay the amount off in one year instead (monthly payment of $865), it will save you over $45,000 in interest payments and you’ll be debt free much faster!  Now you can focus on investing to grow your money even more!

You can click here to download the spreadsheet** and plug in your own values for any debt you have or may be considering (hopefully not anymore!). See how much you can save either by paying it off as fast as possible or avoiding it altogether. 

How to Pay Off Debt

The bottom line is that you need to spend less than you earn and use this extra income to pay off your debt.  You can do this by increasing your income, but even more effective is to reduce spending, or do both.  It may seem like a sacrifice at first, but in the long run, it will be worth it. 

In addition to doing the above, these tips can help you pay off debt more efficiently:

• Start now and pay more than the minimum amount!  Pay as much as you can as fast as you can to save money on interest expense.
• If you have multiple sources of debt, pay off the ones with the highest interest rate first.  Once you pay off the highest one, move on to paying off the next highest as fast as possible, and so on, until they’re all gone.
  • While doing so, be sure to pay at least the minimum amount on the rest to avoid additional late fees
  • Another option, while not as efficient, is to pay off the smallest loans first.  This “debt snowball method” can be helpful to provide a boost of motivation/accomplishment as you say goodbye to that debt source forever.*** You may end up paying a little more in interest expense.  However, if this approach motivates you to pay off debt even faster, it can be worth it!
• If you have sources of debt with a high interest rate, you may also benefit from a balance transfer.  For example, if you have $10,000 in credit card debt at 20%, but already have an open home equity line of credit at 4%, use your line of credit to pay off the credit card debt to save a bunch of money from a lower interest expense!  Some credit cards will also allow you to transfer a balance from one card to another with a lower, or sometimes even temporary 0% rate.  Just be careful – unless you’re paying it off quickly, they may then jump to a rate even higher than what you were originally paying, or charge a balance transfer fee that won’t make the potential savings worth it.  A Google search for “balance transfer” will give you plenty of info on how to do one and what options there are.  This one is a good brief overview while this one does a better job explaining some pitfalls to watch out for.  You can also post questions in the comments below.
• Sell things you don’t need and use that money to pay off more debt ASAP – anything sitting in storage (and save on storage expenses too!), things around the house you’re not using (and should probably give away anyways) or even your nicer newer car (and get a cheaper, used, reliable one instead, waiting on that nicer one until you can actually afford it).
• If you have any savings or investments (except for 401ks and IRAs, which may protected from creditors and can come with a tax penalty if cashing out early), you may be better off using them to pay off your debt. Unless you’re getting guaranteed returns that are higher than the interest rate on your debt, you’ll save more money paying it off than you will earn from investing.
• If you have medical debt, let the hospital know you’re in a tough spot financially and see what they can do to help you. Many hospitals would rather get something from you than send you to collections where they will only get pennies on the dollar for your debt instead.
• With credit card debt, it’s best if you address it before it comes to this, but if you’re already in too deep with no other way out, you may be able to negotiate paying off a lower amount in exchange for forgiving your debt. To do this, you still need to come up with a significant amount of cash for a one time payment, risk your account being closed, and harm your credit score, which could cost you down the road.
• If your debt is long past due and the original creditor thinks there’s little chance of collecting debt, they may sell your debt to a debt collection agency, which pays an average of 4 cents for every dollar of debt. Since they get a severe discount and would rather collect something than nothing or avoid taking you to court, they will often settle for a lower amount if you can come up with a decent amount in a short time. Again, it’s best to take care of your debt before letting it get to this point. Here are some negotiating tips. Trying these steps yourself first shouldn’t cost you anything but time. Debt relief companies or debt and bankruptcy lawyers might help, but they will cost you (while making a lot of money at your expense) and are often not worth it if they are things you could have done on your own.

Is All Debt Bad?

In 99.999% of cases where debt is used to purchase something that will be worthless in a few years, YES!  Avoid it at (almost) all costs!!!  Debt for mortgages or student loans can be different.  With a mortgage, you’re borrowing money now and saving money on rent to get something that will still have value many years from now (rent or buy calculator).  With a student loan, you’re investing in your future, and hoping the education you get will be worth more (in terms of future earnings and quality of life) than the loan payments.  What’s important is to consider the actual costs and benefits of each, and make an informed decision. 

*Assumes an investment return rate of 7% (average annual return on S&P500, adjusted to account for inflation).  If you were able to invest at the 20% rate credit card companies get instead, by golly would you be rolling in dough.  That same $156/month invested for 30 years at 20% would be worth over $3.5 million! 

**Note the excel file is macro enabled (to dynamically adjust the amortization chart and graphs), so you will need to click “enable editing” and then “enable content” in the yellow banner at the top of your file before it will allow you to edit the values and click the button to update the table and graphs.

***I haven’t read the Total Money Makeover by Dave Ramsey (yet), but when it comes to paying off debt, I’ve heard from a lot of people that he’s a great resource and motivator.