How to Tackle Debt

If you’ve made it to this page I’m assuming you’ve made the potentially life changing decision to take back control of your life by getting out of debt but want help with the drive and commitment that is required to stick with this decision. Within this post we will outline what how people get into debt, why it can seriously cripple you and finally a X step plan to finally become debt free. 

What is Debt?

The definition of debt (according to the oxford dictionary) is ‘a sum of money that is owed or due’ or being in debt is ‘the state of owing money’. Put simply debt is money that you have borrowed from a person or an enterprise which you will later have to pay back. If I give someone £10 with the agreement that they will return the money next week they are in a state of debt to myself. (There are other types of debt such as personal agreements, favours or owing someone your time but these will not be covered in this post).

The real problem with debt is not the fundamentals of borrowing money but simply the caveats that come with it. Theoretically I could borrow £1,000,000 and use it to purchase stocks, bonds or real estate and then pay back the money when I am ready and my investments are now worth much more than the money I originally borrowed – a great deal. However,unless you manage to get a “small loan of a million dollars” from your father, the above will almost certainly never be the case in the real world. So what are these caveats we mentioned above that make debt so dangerous?

1. Interest – This is present on nearly all loans and essentially means that you always pay back more money than you borrowed. Interest is usually calculated as a percentage of the money you owe for each year that you owe the debt. An example is below:

• You borrow £10,000 with an interest rate of 10%. Assuming you are not currently repaying the loan at the end of the year you will owe £11,000.
• You borrow £200,000 with an interest rate of 4% and pay it back over 30 years (many home mortgages are similar to this) you will repay a total of £343,739  during the duration of the loan.

2. Collateral – The value of the money you borrow is secured against something that you own. The easiest example of this is when taking out a mortgage for your home. If you do not keep up to date with the repayments of your home then legally the bank can repossess your property, sell it and use the money from the sale to repay the loan.

How do people get into debt?

There are endless and creative methods that cause people to get into debt and in this section we will break these down into their respective categories to review:

Mortgage/Property debt – The most common type of debt for the majority involves us borrowing money from a bank to be able to purchase a home to live within. If you plan to buy a house in the future and unless you are an extreme outlier you will need to make use of a mortgage. In order to qualify for a mortgage you need to provide a deposit (10% of the value of the house is the normal starting point), have a good credit score and have enough responsible income to afford the repayments. Mortgages tend to have the lowest interest rates you will find, long repayment times but can be hard to qualify for. The same principles also apply to a property as an investment (E.g. buy to let) but the interest rates tend to be higher and they are more difficult to qualify for due to their higher risk. In all of these the house is used as collateral in the event that you are unable to complete your repayments.

Car debt – Whether taking a bank/ car dealership loan to purchase a car or signing a lease agreement you are essentially taking on debt which you need to repay. In this day and age it is getting increasingly common to go into debt to have the privilege of driving around in a shiny new motor. To see the real cost of new car ownership please see *** Interest rates for car loans are moderately high and certainly much more than a mortgage.

Credit card debt – This small plastic card can be one of the most powerful financial tools to increase your wealth but also decimate it. When purchasing items or paying bills with a credit card you are immediately racking up debt which must be repaid in the future. Credit card debt generally works in the following way although there are exceptions:

• Debt can be cleared interest free after 1 month
• After one month the minimum balance can be paid (this will be a percentage of the money you owe). The money you do not repay stays as debt which you will now be charged interest on.
• If you do not pay the minimum balance you will usually incur late fees, damage your credit score and possibly increase your interest rate.

Credit cards mean that as long as you are approved for one by an institute you can begin to purchase items you can’t realistically afford. Instead you realise you can afford to repay the minimum balance each month but don’t realise that the debt you are not repaying is building bigger and bigger with high interest rates. For a deeper dive into credit card debt a post will be created in the future.

Business Debt – Often entrepreneurs believe that the only way to begin a business is to go into debt. The famous saying ‘it takes money to make money’ is believed by many although the origins of this were actually from a Roman playwright (Plautus) who used it in one of his comedies. This debt often has low interest rates but as the loan sizes can be large repayment amounts are often high – this is a huge reason for why so many businesses fail. To learn more about starting a business without debt I recommend the ‘Rebel Entrepreneur with Alan Donegan’ podcast.

Good sources of Debt – Mortgage (0% or similar loans for products, credit card)

So far we’ve only really discussed the dangers of debt and how it can negatively affect your life. However if understood and well managed debt can be a great weapon to leverage your funds, increase your net worth and own items that would otherwise be unobtainable. Some of the most common sources of good debt are:

Mortgage- At the top and the most powerful source of good debt for us everyday folks is a mortgage. As discussed earlier a mortgage allows you to own a home that you can’t afford out-right and pay a low interest rate as you repay it. The benefits of a mortgage are:

• Provides you with a place to live
• Mortgage repayments are often lower than rent
• If the property increases in value (as they usually but not always do) your investment is leveraged and you can utilise the gains. E.g.
• Purchase a property for £200,00 with a 10% deposit (£20,000). Over 5 years property value increases to £220,000. Your ownership of the house is now worth £40,000 (100% increase).
• Allows you to utilise house hacking to live for free – see blog post ***

0% Interest Loans – This is a pretty simple concept and one that you should take advantage of whenever possible. To entice new customers businesses will sometimes offer to spread the payment of their product or service over a period of time and charge you no extra for this. This has two benefits – Your currency is devalued each year (due to inflation) and you are able to invest the yet to be spent money into something that can generate a return. For example, I have a sofa (couch) which I am repaying over 4 years and not paying a single extra penny. Take advantage.

The below can all be sources of good or bad debt depending on how well they are understood, the circumstances and how the funds are spent.

Credit Cards – We’ve already discussed the dangers of credit card debt but if used responsibly the benefits are:

• A month long interest free loan on whatever you buy
• Cashback or rewards like air miles when making purchases
• Increase in your credit score
• Additional customer protection – as technically the bank has bought the item they have a larger interest in resolving any issues that may occur.

Business Debt – Again like credit cards we have already discussed the dangers of putting your business into debt but there can be good reasons for this:

• Take advantage of unique opportunities that are presented
• Invest in facilities that increase production and ultimately profit
• Exponentially grow – this may be through opening a second store or using paid advertising.

Understand what got you into debt – One key exercise to becoming debt free is to remove judgement of yourself and determine the reasons of why your previous actions led you into debt. Only once you understand the activities which led to your unwanted circumstances can you begin to put in place a plan to ensure you do not end up back in a similar or worse situation. Take a few minutes to think about:

• Which areas of your life are unsustainable with your current paycheck (home, car, gadgets, eating/drinking out, holidays, hobbies).
• What are your reasons for spending your money on these pursuits? Are you doing it for yourself, are you doing it to fit in with those around you or are you trying to impress others?
• What is the value to yourself of each of these
• For those that do not bring you value can they easily be removed from your life?
• For those that do bring you value can you find a way of minimising costs without affecting the enjoyment they bring.

In these situations I find that an example is often useful to show how this can be applied to each of us. (One point to note is that the severity of your debt should determine how extreme you are in removing items/experiences from your life – If you’re drowning in high interest debt then a cheap holiday isn’t a good idea):

Unsustainable Action	Reason for Why I Spend Money Here	Value to Myself	No Value – Can be Removed?	Adds Value – Minimise Costs
New leased car	Need to drive to work each day Believe I need to look professional at my job Like to impress my friends	Transport	No – Still need a personal car	Could end the lease (if possible) and instead purchase a sensible used car that meets all of my requirements but costs a lot less
Eating out twice a week	Date nights with girlfriend Catch up with mates	Evenings to relax and see people I’m close to	No – Enjoying time out with friends and dates with girlfriend	Reduce frequency to once a month with both girlfriend and friends until debt is resolved Invite friends to house to cook, eat and spend time together
New Clothes – roughly every month	Like to impress others Get bored and impulse buy	Very little – already have plenty of clothing to choose from	Yes – Can be reinstated if desired once debt has been paid off	N/A
Subscriptions to Netflix, Amazon Prime, HULU, Now TV, Sky, Disney+ etc.	Entertainment for myself when home and relaxing	Helps me to relax and enjoy alone time	No – Need entertainment while at home	Cancel all subscriptions except for one. Watch favourite programs and then cancel and subscribe to another service. Rinse and repeat
Beer at the pub after work	Always been the norm since I started working – my dad has also always done the same	No value – Unhealthy, expensive and don’t even socialise when I’m there	Remove immediately	N/A
Expensive foreign holidays	Love to see new places and get away from work	Explore the worldHave new experiencesSee new culturesSwitch off	No – Big part of my life and not something I want to cut off.	When possible try to holiday in this country or only go abroad when you can drive or get cheap flights.Get away from hotels – experience hostels and backpackingVisit countries with a cheap cost of living

How debt can ruin your life (compound interest)

Compound interest is one of the wonders of the financial world and is something that I have spoken about often on this blog. “Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.” When investing into something like an index fund compound interest works for you and each year (if averaged over a long period) your money will grow more than the previous year until you’re making more money from compound interest than you could hope to invest. An easy way to understand this is the picture below:

In the graph you can see what would happen if you invested £1000 every month for 40 years with a 10% return. The green total deposits shows the money you have personally invested and the orange is the money earned from compound interest.

(link https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php)

Unfortunately compound interest works against us when we have debt that we are not repaying and instead of it being a powerful tool in our path towards financial freedom it can become at best an anchor holding us back and at worst a lifestyle crushing burden. Unfortunately interest rates on credit cards are extremely high and below is an example of how your debt could spiral into the ether. We will assume you have a credit card debt of £10,000 which you are not repaying (we will ignore late fees etc. for the sake of this example) and at an interest rate of 24%:

Year	Yearly Interest	Total Interest	Balance
0	—	—	£10,000.00
1	£2,193.91	£2,193.91	£12,193.91
2	£2,675.24	£4,869.15	£14,869.15
3	£3,262.16	£8,131.30	£18,131.30
4	£3,977.85	£12,109.15	£22,109.15
5	£4,850.55	£16,959.70	£26,959.70
6	£5,914.72	£22,874.42	£32,874.42
7	£7,212.35	£30,086.77	£40,086.77
8	£8,794.68	£38,881.45	£48,881.45
9	£10,724.16	£49,605.61	£59,605.61
10	£13,076.94	£62,682.55	£72,682.55

If you currently have credit card debt take a couple of minutes to really get familiar with the above and understand just how quickly your life can spiral out of control if you start to miss payments. In just 10 years your debt has increased by 7fold. In 20 years if unchecked you would owe over half a million pounds. Crazy.

12 Step plan to clear your debt and retake control of your life

1. Cut up each of your credit cards
2. Use a spreadsheet to record all debt you currently have and the relevant interest rate on each
3. Ensure you’re paying the minimum balance on all cards – Set-up direct debit
4. Split into high interest ‘consumer debt’ and useful debt
5. Call a free debt charity and get personalised debt advice
6. Inact small tips to improve your credit score (this will help with the next step) https://www.moneysupermarket.com/credit-monitor/
7. Review the use of a 0% balance transfer card (some with fees and some without) or a consolidating loan – Only to be used if you are absolutely committed to paying down the debt whilst you benefit from a window of reduced interest; if you aren’t this could make the situation worse .
8. Develop a budget and track your spending each month – review and trim the fat where possible
9. Create an ‘emergency fund’ – 57% of Americans don’t have enough available cash to pay an unexpected $500 bill without using credit. A month’s minimum living expenses is enough when you have high interest debt.
10. Prioritise and begin paying off as much of your ‘bad debts’ as possible (whilst paying all other minimum balances) using either:
    • Snowball method – Begin by paying off the smallest debt you have and then moving to the next smallest. Enjoy the satisfaction of completing removing some of the debts from your life quickly.
    • Avalanche method – Funnel all of your money towards paying off the debt with the highest interest rate regardless of the size of the debt. Enjoy the satisfaction of the most cost efficient path.
    • Hybrid method – Start with one of two small debts to get the feel good factor and then move immediately to the highest interest debt regardless of size.
11. Once all ‘bad debts’ are gone (the mortgage can stay) save an emergency fund of 6 months living expenses using money previously being used to pay down debt
12. Funnel money towards investments – starting with a pension and an ISA.

Tips to turbocharge your path to a debt-free life – these do not have to be permanent but will help while you’re paying down your balances

• Make your morning coffee at home
• Sell unwanted items around the house for a cash boost 
• Learn to cook and enjoy homemade meals for breakfast, lunch and dinner
• Don’t close an account once you have it paid off – your credit rating is improved by you having access to credit but not using it. Keep the card cut up until you’ve proved yourself responsible.
• Use cash instead of a card – it’s much more difficult to hand over cold hard cash instead of a plastic card
• Make more money – Second job/side hustle or overtime
• Know your value and ask for a raise
• Check if you are entitled to any other benefits – 
• Get help with your energy bill https://britishgasenergytrust.org.uk/
• Check if you are eligible for tax credits
• Check if you are eligible for child benefits
• Check if you are eligible for government benefits
• Check if you are eligible for a free grant
• Get an authorised overdraft with your bank
• Never use a payday loan – do anything you can to keep away from this
• Remortgage or further advance – If you’re responsible enough to use the money to pay down debts and not make things worse
• If you have a serious debt problem and you can no longer afford your minimum payments call your credit provider, explain your situation and explore options
• Consider bankruptcy If you absolutely can’t pay off your debts then bankruptcy might be for you. It costs a steep £680 but it means any money you owe will be written off.  It also means that anything you own may have to be sold to pay off debts – this can include your home, car or any luxury items. You should make sure you get free, independent debt advice before opting for bankruptcy as it can have a long-term impact on your life. Find out more: Citizens Advice has a useful guide to how bankruptcy works and how to figure out if it’s right for you.

If you can do what most cant and a achieve a ‘bad debt’ free status make sure you take some time to celebrate, enjoy your new freedom and ensure you maintain your new fantastic habits.