Before we dive into the world of investing and learn about how to grow your money and build wealth, I believe it’s very important to address the issue of debt. You want to build a solid foundation on which everything else in your life (financially) will rest on.
If you or your loved ones are in debt, I hope this post will be the wake-up call that lights a fire in you to start taking control of your messy financial situation in order to build a joyful financially stable life.
If you are not in debt, then hopefully you still get to learn a thing or two which will help you avoid making financial mistakes in the future.
Okay, let’s get into it by firstly making a distinction between 2 types of debt:
1. “Good” Debt – also known as leverage
‘Good debt’ can be a powerful tool if used appropriately and responsibly. For example, a house mortgage could be considered as good debt. You take out a mortgage to buy a house, which hopefully increases in value in the future. This gives you the option of selling the house later on at a higher price than the cost of the mortgage taken, pocketing a nice profit.
This concept is known as leverage. You use debt to acquire an asset, in the hope of selling the asset at a higher price than the cost of debt. Leverage can be quite attractive when you would like to purchase something which you believe will go up in value, but you don’t have the money to buy it outright in the present.
Note: leveraging carries a level of risk. Generally, house prices indeed tend to go up, but this is not the case all the time. For example, look up what happened to house prices in the US during the 2008 financial crisis.
2. Consumer Debt – avoid it like the plague
Consumer debt refers to any purchase you make where the “thing” you’re buying definitely does not go up in value. The most common example is cars.
A lot of people get a car through a finance deal: Hamzah sees a nice-looking car in which he can imagine himself revving the engine, demonstrating his big d*** energy and getting all the girls in town w**. The car costs £20,000 which Hamzah doesn’t have so he puts a 10% deposit and gets a 5-year finance deal for £18,000. Hamzah owes the lender £18k + the interest on a car that decreases in value each year. Never mind the fact that in total he most likely paid £23k for a car that should’ve cost him £20k.
Up to you whether you think that Hamzah’s right. I prefer to outright buy an okay, not so fancy car that gets me from point A to point B for £1,500 and put the rest of my money somewhere else.
Interest is how these lenders make their money. They make money by ambushing your future income. Here’s a food for thought: If you work 160 hours a month, and you have a car payment of £250 a month, assuming you earn £7.50 an hour, you’re essentially working ~33 hours a month for free.
Now, of course, you could justify having a car on finance because you need it for your job if you were working as an uber driver or in the food delivery services, and therefore the £250 is more like leverage as it’s allowing to make more money. Otherwise, I would avoid it if possible.
I’m being very critical of car financing because it’s the most common trap I see people get themselves in. In the UK, around 91% of new private cars are purchased on finance.
From here forward, whenever you see the word ‘debt’ think ‘consumer debt’.
Okay, so we went through the 2 types of debt and now you have a pretty good idea of which one to avoid and why. Let’s now talk a little bit about why debt is so harmful:
Reason #1: It can potentially destroy your mental health Some people have committed suicide because they were drowning in debt. It has been increasingly shown to cause anxiety, depression, anger, frustration and other unpleasant feelings.
Reason #2: Debt can hurt your relationships with your loved ones Debt can put serious pressure on the household’s finances and create a lack of financial security for all members involved. When people feel overwhelmed, arguments about spending habits, who is creating more debt and so on start to arise.
Reason #3: It limits how much you pay yourself first When you are in debt, the lenders are getting your money before you even get the chance of paying yourself first, and if you’ve read my post about budgeting then you know how crucial this concept is for building wealth.
These are just a few reasons as to why it’s important to eliminate debt. If you or your family are not in debt currently, then good for you. Make sure you do NOT get into it. My rule of thumb is, if you cannot afford to buy something outright, do not buy it. Save for it. Build good habits. Patience is a virtue.
I’ve talked a lot about why consumer debt is bad for your finances, but it’s really important to drill this into your soul. Please don’t be naïve when it comes to debt spending. Various research has shown that credit cards are especially dangerous and dopamine-(the feel-good hormone)-inducing because they disconnect the pleasure of buying from the pain of paying. Nevertheless, this doesn’t mean that credit cards are Satan’s tool. There are effective ways to use them which I’ll probably cover in a future post.
Alright, enough with the babble. Here’s what you need to do:
Step 1: Make sure you’re paying the minimum monthly payments Firstly, you need to make sure you’re only paying the minimum allowed monthly payments towards each debt you have. This will allow you to build your emergency fund faster. See step 2.
Step 2: Build a £1,000 emergency fund. This is common sense. Once you’ve made up your budget and decided to take control of your finances and live debt-free, you want a cushion in case of an emergency. If the washing machine breaks down, you don’t want to get into more debt to fix it. That would be counter-productive.
If an emergency did arise and you had to use the fund, then make sure you build it back up before continuing with the following steps.
Step 3: Choose the debt pay off method that suits you best To get out of debt, there are 2 popular methods: Snowball & Avalanche method. For the snowball method, make a list of all your debt and sort them in order of smallest to largest balance. This is the order in which you’re going to clear out the debt. Yes, that’s right, balance and NOT interest rate. When it comes to personal finance, psychology and behaviour can sometimes have a bigger say than the maths. Yes, you would save a little bit of money by paying off the highest interest rate debt first, but the debt snowball has proven time and time again to be extremely effective. The dopamine rush and feel-good hormones you get when you pay off that first small balance can be extremely motivating. It will encourage you to keep going at it.
Paying off debt, especially if you have a lot of it, is a long-term game. It can take years. If you choose to use the avalanche method (where you list the debt in order of highest to the lowest interest rate) it can sometimes take you a couple of years to pay off that first debt balance, and getting that first win becomes harder, so you’re most likely to give up on your plan!
Which method you use is a personal preference. I tend to prefer and recommend the snowball method.
Note: you might be thinking, well of course this does not apply to me. I’ll use the avalanche method and save myself some money. Only peasants need that “quick-win” in order to stay motivated and on track. To that, all my reply would be to look up the ‘Dunning-Kruger effect’ on the internet and have a read through.
Step 4: Power of compounding Any money you have left over after budgeting, use it to overpay towards your debt number 1 on your list. Once you’ve paid that off, you’ll carry the fixed monthly amount for that debt onto the next one. Let me explain with an example:
Each month, you pay a fixed amount (£150) towards the Car Finance deal + A variable amount which you can afford from your budget (£500 below):
Once the car finance deal is paid off, you’ll add this £150 payment towards the HSBC Loan. Call up your bank and set up a standing order (a direct debit). See what I mean by snowball? Once one debt is paid off, the fixed monthly payment for that one will add towards the next debt, growing in size each time you pay a debt off. Like a snowball.
The avalanche method uses the same principle.
Step 5: Laser Focus
You’ve got to have self-discipline. If you’ve committed yourself to live debt-free and no longer let lenders have their hands in your pocket, you’ll need to develop a laser focus mindset. Once you’re in the debt elimination stage of your personal finance journey, that means:
No to buying unnecessary stuff just for a quick dopamine fix.
No to eating out unless it’s a special occasion. As Dave Ramsay would say “You’re going to be on rice and beans, and beans and rice”.
No to unnecessary spending.
No to ‘acting’ rich. You’ve decided to build genuine, real wealth. Not trying to look rich. As the saying goes ‘Wealth is silent, rich is loud, and the poor is flashy”.
I hope you got some value out of this post. As always, thanks for reading and if you have any questions, please don’t hesitate to get in touch. Best of luck to you and your family on your debt eradication quest!
PS: I have nothing against Hamzahs.