Step 2: Pay Off Debt

Step 2: Pay Off Debt

paying off debt

Welcome to Step 2: Pay Off Debt. In this step, I will talk to you about the debt portion of the steps of Financial Independence. If you have no debt, the following will probably be irrelevant. However, seeing as how so many people out there are in debt, this may help them.

Once you have your emergency fund set up, it’s time to pay off debt. This is where you could actually start investing a little bit if you can afford to. Unlike Step 1 where building an emergency fund is a MUST MUST MUST, Step 2 has a little bit of flexibility. That is to say, the emergency fund is the most important foundation in personal finance.

Max Out Free Money

Firstly, before anything else, if you have an employee sponsored retirement plan, like a 401(k) or a TSP that has company matching, I would start to contribute some money into that in order to get the employee match.

Employee match is guaranteed FREE MONEY 

…(assuming you’ve worked there long enough to be fully vested)

If a company matches you dollar-for-dollar, then that means, for every dollar you put into your retirement fund, your employer will give you a dollar into that same retirement fund. As a result, this is the best return you can get. However, some employers only match $0.50 for every $1 you put in. Additionally, there is a cap on the amount they will contribute, usually between 3% and 6% of your salary. However, no matter what the employer provides, this is a guaranteed return on your money. Most importantly, this will serve as a foundation of your future nest egg in retirement. Additionally, you pay no taxes now on free money.

Pay Off Debt

Once you’ve reached that limit, assuming you had spare cash to contribute to your retirement fund, then it’s time to start tackling all your debts aggressively. That’s not to say you shouldn’t be paying off your debts in the first place. However, once the employer matching is taken care of, then it’s time to take care of all your remaining obligations.

There is no reason anyone should be giving away free money to the creditors in the form of interest payments. However, there will be cases where this is inevitable. For instance, if your interest payments are extremely low and you can find better returns on your money, then by all means. But for now we will look at ways to pay off debt.

Ways to Pay Off Debt

Firstly, we will cover two methods to pay off debt. Make sure you understand these two strategies for the example I’m about to show you, courtesy of Dave Ramsey’s teachings:

Paying off Debt – The Debt Avalanche Method
Paying off Debt – The Debt Snowball Method

Now let’s look at a real world scenario. Suppose have the following debt balances:

Account Balance Interest Rate Minimum Payments
Sallie Mae (Student Loan) $27000 4.2% 120
Chase (Credit Card) $10000 11.7% $230
Capital One (Credit Card) $5000 19.9% 80
Honda Financing (Car Loan) $14000 4.2% 300

Pay Off Debt: The Avalanche Method

First we apply the Debt Avalanche method and rearrange our accounts in the following order:

Account Balance Interest Rate Minimum Payments
Capital One (Credit Card) $5000 19.9% 80
Chase (Credit Card) $10000 11.7% $230
Sallie Mae (Student Loan) $27000 4.2% 120
Honda Financing (Car Loan) $14000 4.2% 300

In this table above, the order of accounts are arranged by interest rates from highest to lowest. As you can see, this is the order in which we pay off debt. First, we aggressively pay off the Capital One credit card balance. Then, we make minimum payments on the rest. This method illustrates minimizing the free money we give away. After all, why should these big corporations take our charity. Therefore, aim at paying the highest interest rates first and reduce interest payments.

After that, once the Capital One account is paid off, we focus on the next highest interest rate: Chase credit card. Similarly, we repeat the steps above here. As a result, once we pay off the Chase credit card, you will have the following two accounts left:

Account Balance Interest Rate Minimum Payments
Sallie Mae (Student Loan) $27000 4.2% 120
Honda Financing (Car Loan) $14000 4.2% 300

Pay Off Debt: The Snowball Method

Looking at the table above, we have the same interest rates on both loans. Using the snowball method, we will take the cash that’s freed up from our Chase card and our Capital One card. These amounts are $230 and $80 respectively. After that, we take this free cash and apply that towards the car loan. After that, once the car loan is paid off, we will have freed up even more cash which we can then use towards the student loan. More importantly, what we see here is that the snowball method provides us with cash flexibility at the expense of suboptimal interest rates.

Additionally, you may want to use this credit card payoff calculator to determine how long it will take to pay off each debt.

In conclusion, the debt stage might be the longest journey you’ve been on yet. To pay off debt takes a long time. In the end, it will all pay off. Once that’s done, you will never want to be in that hole again.

More importantly, we are now debt free. Above all, you’re 2/3s of the way towards financial independence. It’s a long journey. Lastly, you’re now you’re onto Step 3!

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