Student loans, credit cards, and mortgages—oh my. Like many people, you may have a variety of debt. And like many people, you may be working to pay off your balances while also trying to build up some savings for a rainy day (not to mention retirement).
Trying to juggle so many competing priorities can be stressful, particularly if you’re not sure how best to focus your attentions. So we put together this step-by-step guide to try to help you decide what to tackle first.
Although we may not be able to fund your 401(k) for you or kill your student loans, hopefully we can help take some of the confusion out of the process as you work toward your goals.
Paying off debt and building wealth may seem like competing goals, but with some strategic planning, you can make progress on both fronts. The key is leveraging debt wisely to generate investment returns that exceed interest costs.
The Problem with Debt
Consumer debt like credit cards and auto loans charge high interest, drain cash flow and provide no asset ownership. This “bad” debt hampers wealth building by consuming income that could be invested. Eliminating high-interest debt should be a priority.
Good Debt Versus Bad Debt
However, not all debt is created equal. “Good” debt taken on to acquire productive assets can build wealth if properly structured.
For example, a mortgage provides leverage to purchase an appreciating asset that builds equity. Student loans allow pursuit of higher earnings potential. Business loans acquire equipment to increase profits. This debt finances assets and activities expected to generate returns exceeding interest costs.
Use Debt to Increase Investments
This is called “gearing.” <b>Providing you invest wisely and your assets increase in value</b>, gearing helps you create wealth, as the income (and capital growth) from the investment pays off the debt and exceeds the costs of servicing that debt. Property or shares are often a good strategy here.
Gearing magnifies gains, but also losses if investments underperform. So utilize debt cautiously and conservatively based on risk tolerance.
Pay Down Debt While Investing
Ideally, simultaneously pay off bad debt while strategically leveraging good debt to invest. Create a budget that directs surplus income to high-interest debt repayment and sound investments.
Investment returns should exceed interest costs on the good debt. Earnings can then be utilized to pay down principal debt balances over time.
Talk to a Financial Advisor
A financial advisor can review your unique circumstances and create a customized wealth building and debt repayment strategy. They can structure your finances to prudently leverage debt, maximize returns on invested capital, and allocate earnings to debt elimination.
The key is aligning smart debt with intelligent investments, so the borrowing is productive rather than destructive to your balance sheet. Wisely utilizing debt as part of an overall wealth creation plan can help you build assets while becoming debt-free.
Step 4: Pay off any credit card debt
If youve been carrying balances on any credit cards, now is the time to start chipping away at them by paying more than your monthly minimums. Eliminating this debt is important so that you dont get stuck on a high-interest treadmill.
What if youre carrying a balance on more than one card? There are 2 common strategies to tackle credit card debt: the snowball method and the avalanche method.
Snowball method
In the snowball method, you start by paying extra on the credit card with the smallest balance until its paid off. Then move on to the card with the next smallest balance, paying the minimum payment plus the amount you were paying on the first card. Continue this until all your cards are paid off. The benefit to this method is that it helps build momentum and its satisfying to see zero balances.
Avalanche method
In the avalanche method, you start by paying extra on the card with the highest interest rate until its paid off. Then move on to the card with the next highest interest rate, making the minimum payment plus the amount you were paying on the first card, and continuing this approach until all your cards are paid off. The benefit to this method is that you may save money on interest, especially if your cards have a wide range of interest rates.
Once your cards are paid off, if you continue to use them, make sure to start paying your balance in full every month.
To learn more about the debt snowball and avalanche methods, read Viewpoints: The debt snowball method vs. the debt avalanche method.
Step 3: Capture the full employer match
Next, its time to look around for any low-hanging financial fruit. That means trying to contribute enough to your 401(k) or other workplace retirement plan to capture the full amount of any matching dollars your employer provides.
Your employers match is essentially “free money,” so not taking advantage of it is a bit like leaving money on the table. (That said—look into whether your employers contributions take time to vest, and think about whether youll stay at your job long enough for them to fully vest before you start banking on that free money.)
Best Way to Pay Off Debt Fast (That Actually Works)
FAQ
How do you build wealth after paying off debt?
- Step 1: Pay off Debts. Think of debt as missed opportunity. …
- Step 2: Buy a House. …
- Step 3: Start Long-term Investing. …
- Step 4: Put an Estate Plan in Place. …
- Step 5: Share Your Financial Wisdom.
Is $20,000 a lot of debt?
If you’re carrying a significant balance, like $20,000 in credit card debt, a rate like that could have even more of a detrimental impact on your finances. The longer the balance goes unpaid, the more the interest charges compound, turning what could have been a manageable debt into a hefty financial burden.
Does paying off debt increase net worth?
Net worth is equity minus debt, so lowering that debt increases net worth considerably. Making smart investments, not just in stocks, is a surefire way to increase net worth. Buying a sensible car or a house, and keeping luxury expenses low, are all important steps.
How the rich use debt to create wealth?
Leveraged Buyouts (LBOs): Wealthy individuals and PE firms use LBOs to acquire revenue generating companies using borrowed money – as much as 90% of the …