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Make meaningful improvements to your finances every week.

Debt Questions

Five Questions: Debt Month

Holiday spending hangovers make January a debt month for some of us so we are bringing you five questions on how to deal with debt.

Question One

Hey Andrew,

I just started listening to the podcast recently and I’m enjoying the wide range of topics. You guys may have covered this and I haven’t gotten to that episode yet.

If not, my biggest issue is prioritizing my debt payment. I think it’s more of my mindset that I need to adjust rather than a strategy. I know what I need to pay down first, I am just hesitant to spend my extra money towards that debt. It feels better and more secure to hold.

You do need a plan to repay debt. Just throwing money at various debts randomly won’t pay it down as quickly as using a proven method of debt repayment and therefore will cost you more money in interest.

There are two popular methods of debt repayment strategies; snowballing and stacking. We devoted a whole episode to this topic, you can find here. To sum up the two methods:

Snowballing means listing all of your debts in order of smallest to highest dollar amount and then using any extra money to pay off the smallest balance while only paying the minimums on the others. If you have a $5,000 student loan at 4% interest, a credit card balance of $6,000 with 17% interest, and a $10,000 car loan with 9% interest, you pay off the student loan first, followed by the credit card and finally the car.

Once the smallest debt is paid, you move to the next smallest using the same strategy and include the amount you were paying on the first debt into your monthly payment on the next. You continue to do this until all of the debts are paid, the largest being the last one to go.

To use the stacking method, you list your debts in order of highest to lowest interest rate, regardless of the dollar amount of the debt. You throw as much money as you can at the debt with the highest rate of interest. If you have the same debts we listed above, they would be ordered this way; the $6,000 credit card, the $10,000 car loan, and finally the $5,000 student loan.

Once each debt is paid, you move down to the next highest interest rate one, again, using the money you were paying towards the last debt, and do the same. So on and so on until all the debts are paid.

I understand how sometimes it’s hard to do the right thing even when we know it’s the right thing. Interest we’re paying on our debt doesn’t feel as real to us as looking at our checking account balance and seeing a healthy dollar amount so it can be hard to let that money go to something that feels kind of abstract.

So here are some real numbers that might convince you. If you paid off that $6,000 credit card bill at $100 a month, it would take 135 months, ELEVEN YEARS, to pay it off and you would pay, $7,486 in interest alone. That’s more than you initially charged to the card.

Now, if you buckled down and paid $500 a month, it would take you just fourteen months and you would “only” pay $623 in interest. If that doesn’t convince you, I don’t know what will!

Question Two

Hey Andrew,

I thought it might be interesting to get some advice/hear your thoughts on financial planning for young, high net income earners in up-or-out industries.

Personally, I’m a corporate associate at a large law firm – the kind where people stay for a few years and lateral out to smaller firms or go all in and try to make partner. The starting salary for first-years now is $180,000 with roughly a 5.5% salary increase per year of seniority. We also have sizeable market bonuses, though not as great as our friends in the banking/finance industry.

Additionally, our firm partners with a bank to refinance student loans at a measly interest rate of 1.95% (!), which we all view as an incredible benefit to pay down law school debt. I am, luckily, at a manageable student debt amount of $40,000. That refinancing benefit stays with you even if you leave the firm.

What I struggle with is how to balance payment of student loans and investments when my financial picture may eventually be the inverse of most peoples’ pictures – if I leave big law, my salary will go down as I get older, whereas most people see a steady pay increase over their years of work.

I also understand the concept of my investment performance outpacing that 1.95% interest rate, but don’t want to be saddled with large monthly payments if my associate salary takes a hit due to a move to a smaller firm.

I currently save about 25% of my income, including a maxed 401k with no employer match (the drawbacks of a law firm being a partnership, but that’s a topic for another day) and a Vanguard brokerage account that I set up to mirror Betterment’s investment strategy, and put aside $2,000/month for student loans, which includes a monthly payment of $1225 and an additional voluntary principal payment of $775.

I just want to make sure I’m maximizing my savings/debt reduction while I’m young and earning a big law salary, and attacking the two financial areas with the right tactics.

Would love to hear you all do a few minutes of podcast on the topic generally, or give some thoughts on the website. Just recently discovered the show and feel like I’m learning cool shit every day. If you ever need a corporate lawyer to join the podcast (for whatever reason), we’ve got people for you!

Best, Brett R. Schroeder

It seems your employer has further incentivized you to not pay your student loans. Essentially, interest rates are the cost of money. So, if I borrow $100 at 4%, the cost of that $100 is $4. If the rate goes up to 8%, the cost doubles and if it drops to 2% the cost halves. You’ll still have to pay back the loan no matter what, the question is what’s the most effective thing to do?

I’d encourage you to listen to this episode, even though we’re discussing mortgages for real estate the concept is the same. I also think this quote is very fitting:

“Leverage is the reason some people become rich and others do not.” – Robert Kiyosaki

Think on that. It is how our “brilliant” president has built/maintained his wealth (minus a million bankruptcies and general business incompetence). I own just shy of $1,000,000 in property, a privilege I owe to saving only $200,000. However, the kicker is I earn income on the full value of the property and only pay the bank a small portion of that. A laughable portion.

Now, I’m not suggesting that REI is the answer for you but investing in some fashion is not only important but a necessity for you. If your income burns out in two years would you rather a) have zero student loans and zero savings or b) a series of investments earning you on average 7% a year?

I don’t see a scenario where it makes sense to invest in a 1.95% asset. That’s not all that different from me suggesting you pump all your money into a savings account as a solid approach towards building wealth. Hell, inflation is at 3% so technically your debt is getting cheaper without taking any action at all. If inflation is 3% and your interest rate is 3% your effective rate is 0%.

So, save like a beast, slash expenses, invest in some fundamentals like Betterment/Vanguard and after you get a solid base, actively look for higher returns. Don’t put more than the minimum into your student loans until you’re incentivized to do so (the rate goes up).

Hope that helps!

Question Three

Guys-

Quick question for you. This summer, I’ll be getting an about $500 raise at work. Also, my wife will be starting her own business at the start of the new year. We are debt-free except for our mortgage. I was planning on taking my raise and whatever my wife makes in her business (we have no problem living on my paycheck alone) and putting it towards a down payment on our first rental.

Or, do I put it towards the house mortgage? If I take my $500 and ballpark $1000/mo for my wife’s business, we’d reduce our 30-year mortgage to 9 years and save about $152,000 in mortgage interest. Then, we could really save for some rentals.

I’m leaning towards paying off the mortgage at this point. Thoughts?

Thanks,

Phil

First of all, congratulations to your wife on starting her own business. While I hope she will make $1,000 a month (and more), it’s risky to count on that income right now. I would wait for a few months to see how the business is doing before making any major financial decisions.

That said, I have become a big fan of owning rental property. An asset is something that makes you money. A home you own to live in only ever costs you money until the day you sell it and then only if the conditions are in your favor and you sold it for enough money to make up for all the money you spent to own it; property taxes, maintenance, upgrades. Paying for those things doesn’t end when your mortgage does. Owning a home to live in, even outright, never stops costing you money.

The right rental property is putting money in your pocket from or almost from, the beginning. I’m in a situation similar to your own. I own a home, I have a mortgage but I have recently begun buying rental properties. Everyone should have more than one income stream and at least one of those streams should be passive, as rental income is.

With that additional income, you may be able to pay off the mortgage on your home even sooner than nine years. Once you see how things are going with the new business, I vote for buying rental property.

Question Four

My girlfriend has about $8,000 in credit card debt along with $100k of student loan debt from undergrad/grad school. What route should be taken to get rid of the 8k (Lending Club?, transfer to another C.C?) and what should be done about the 100k loans because her payments are income based and are almost $1,000 a month because of this?

Demetrius H.

There are some great transfer balance credit card deals available right now, some of them offering 0% APR for a whopping 21 months. Some of them come with balance transfer fees, usually about 3% of the balance being transferred so be aware of that. She also must pay off the $8,000 in full before the 0% APR period runs out or the remaining balance will be subject to the regular APR which could be higher than what she is already paying.

If she can’t get approved for a balance transfer, Lending Club is a great option. Your girlfriend will certainly be paying a much lower interest than she is currently but it won’t the 0% APR that she can get with a balance transfer card.

With a loan that big I hope she has a degree that is earning her or will earn her in the future enough money to have made taking out student loans that big a good investment.

Income-based repayment plans are already one of the best options for lowering monthly student loan payments, they are capped at a certain percentage, usually 10% of a person’s monthly income. She can look into refinancing the loans with a company like SoFi.

This may lower her interest rates and she could opt to repay the loans over a longer period of time. It would lower the monthly payment but it would mean paying more in interest over the long term.

She would also lose certain protections she has if her current loans are federal so be sure she is aware of that. Some of the refinancing companies offer protections as well but they aren’t as comprehensive as those that are attached to the original loans.

Question Five

How do you know when it’s the right time to apply for additional credit cards? My credit isn’t terrible, but it also isn’t stellar. I have 100% on time payments and one low limit credit card, but I also have one medical bill in collections, which I’m currently disputing.

I wanted to increase my available credit to lower my utilization and tried calling Chase to ask for a limit increase, but they said they’d have to run my credit to determine if I was eligible for an increase, so I balked. I figure if I have to get my credit run regardless, it’s better to get a new card to increase the number of open accounts that I have, increase my number of on-time payments, and increase my credit limit.

I don’t know if I should apply for a new card now or wait until the results of the collection dispute are available to possibly increase my likelihood of getting approved for the new card—suggestions?

Having a good credit score is important because it makes life cheaper. Your score is made up of six factors. If you’re approved for a new card it will increase your score in the areas of utilization and total accounts. However, it will decrease your score in the areas of length of credit history and credit inquiries.

Utilization makes up about 30%, total accounts about 10%, credit history and credit inquiries make up about 5% each. So in your case, it’s worthwhile to apply for a new card. Before you apply, learn your credit score. You can get a ballpark figure on a site like Credit Karma and some credit cards provide it with your statement.

Once you have that number, do some research on a site like Nerd Wallet to learn what cards someone with your credit score is likely to be approved for. Your score does take a temporary hit of fewer than five points when you apply for a new line of credit. That isn’t terrible but you’re trying to improve your score so no sense applying for a Chase Sapphire Reserve when you have a credit score of 500.

If you don’t get approved, wait until the dispute is settled in your favor and send documentation to the three major credit reporting agencies showing that derogatory mark was in error and ask that they remove it. All three agencies, TransUnion, Equifax, and X have on-line portals that will take this information.

Once that is resolved, you can try again to apply for another card.

Show Notes

B.O.R.I.S. The Crusher Oatmeal Imperial Stout: A stout with a deep roasted, full bodied flavor.

 

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