The secret to get out of debt is to first understand the basics. In this article, we’ll explore what is debt, the way it works, and how the cycle continues.

My Story

My first job out of college required me to relocated to the snowy state of Minnesota. Being from the south, I was not accustomed to the winter weather and icy roads. My beat-up car could survive driving conditions down south but I did not want to take any chances up north.

As a fresh college graduate about to start my new life, my father convinced me that I should get a new car. Soon enough, I was a proud owner of a brand new redesigned Limited Edition Toyota Rav4 with AWD. I was enthralled with so much excitement.

Reality Check

I assumed that my salary could cover my new exciting lifestyle. Although, when I got my first paycheck, I discovered the impact of taxes, it hurt and cut deep. Shortly after, it did not take me long to realize that I was living well above my means.

In reality, although I had the keys to the car and could drive it anywhere my heart desired, I didn’t own the car. It was financed. With a small down payment, 0% interest, and monthly payment of $555.50, it took me the next five years to repay the total amount of $38,330.

The Cost of Living

Along with a new car payment, I also needed to pay for my basic necessities: car insurance, gas, student loans, rent, renter insurance, utilities, gas, a gym membership, and my credit cards (for food and gas). There was no extra room in my budget for anything else.

I cut out all entertainment, lived in an unfurnished apartment, could only afford groceries that were on sale for the week, went to three different grocery stores to get the lowest price, and never went out to eat or drink. As hard as it was, I eliminated all that I possibly could just to stop incurring more debt. It felt like my head was barely above water as I  survived living paycheck to paycheck.

Constant Exhaustion

During that time, I constantly stressed over money. Every decision was based on how bad it would impact me financially. So many times I had to say no to social events, skip out on giving Christmas gifts, and even a simple treat from the grocery store.

What hurt the most was not being able to afford plane tickets home for the holidays. I’ll never forget the heartbreak in my dad’s voice when I had to break the news to him. Being in debt was physically, mentally, and emotionally exhausting.

Lesson Learned

Looking back, purchasing a new car after college was not something I was proud of. Sure, I felt the excitement in the moment and the few months to follow. Of course, like every material object, the feelings eventually dissipated. I no longer felt the happiness that it once gave me. Instead, I felt pain with every monthly payment for the next five years.

It was important for me to realize that my decision to get a new car was not the reason I was in debt. Although, it certainly added a large chunk to it. Truth is, that it was a collection of irrational decisions that added up, all of which I could have easily prevented. As expensive as it was, it taught me a life lesson about personal finances and debt.

Debt is a Choice

Debt is a choice. Once we decide that we no longer want to live in debt, we can all work out way out of it. By understanding the basic foundations, we can determine the opportunity cost of each choice, make more informed decisions, and build working systems to help us get out of debt and reach our financial goals

To begin, one of the basic foundations of personal finance is having an understanding of what debt is.

What is Debt?

In its most basic form, debt is something that we owe. It can be a service or favor, but we typically deal with debts in the form of money. There are different types of debt and you may hear that not all debts are created evil. The two main categories are secured vs. unsecured debt.

Secured Debt

Secured debt is a loan that allows banks to take away an asset if we cannot uphold our end of the agreement/cannot make payments. The asset is also referred to as collateral. Auto loans and mortgages fall into this category. Banks can easily repossess a car and foreclose on a house.

Student loans that are backed by the federal government are also a form of secured debt. These are loans that are guaranteed by the government, so the loans are considered to be less risky. It is similar to a guarantor or co-signer for a car or an apartment. The Stafford loan and Parent PLUS loans are common federal loans.

Unsecured Debt

Unsecured debt, on the other hand, is a loan given with no asset or collateral to be backed against. This is more risky for a lender. Banks or lenders do not have anything to take/resell if we cannot keep our promise to repay the borrowed money. Credit cards, medical loans, and private student loans would be examples. A bank cannot take your education away from you or anything that you purchased on a credit card.

Just because a bank does not have a tangible asset to back the loan against, they still have a way of keeping you accountable to pay them back. This is where credit scores, debt collectors, and wage garnishment comes into play.

Negative Consequences

If we fail to pay back what we owe back to our lenders, it will be reflected through our credit score. Payment history is one of the largest determining factors of our credit score, 35% to be exact. A 30-day delinquency could easily drop a credit score by 100 points. As if a significant drop in your credit score is not enough to damage, do not forget about the added cost of late fees and accumulated interest tacked on top.

In addition to a lowered credit score, lenders can sell the debt to a collection company or agency. This has a significant negative impact on our credit score and where you hear all the debt collector horror stories. Courts can also order employers to withhold portions of our paychecks to repay the lender until the debt is paid off.

Importance of a Credit Score

It is just best to avoid all these situations, if possible. Unless you have stockpiles upon stockpiles of cash to pay for a car or house outright (I certainly do not), we should all take good care of protecting our credit score if we plan to borrow in the future.

With a good credit score, banks are more willing to offer favorable interest rates and terms, which could save us thousands of dollars in the long run. That is only if we uphold our end of our promise and pay back all debts, both secured and unsecured.

Understand How Debt Works:

A critical step to overcoming debt is to understand how it works. There are many different types of debts, but here are some of the most important definitions that apply to each:

• Principal or Balance: the total amount borrowed or unpaid
• Annual Percentage Rate (APR): The amount paid annually, which includes interest and fees
• Interest Rate: the percentage rate to borrow money, fees are not included. Rates can be fixed or variable (constantly changing dependent on ____).
• Interest: the cost to borrow money, calculated using the interest rate, balance, and period. Interest accumulates from the date the loan was issued or from the last payment made.
• Plan, term, period: a schedule that interest accrues, common periods: daily, monthly, and annually

In its simplest form, debt starts with a principle or balance. It is the amount of money that is being borrowed to pay for something in full upfront. To make money, banks and lenders charge an interest rate or annual percentage rate for borrowing their money. The interest accrues, builds ups or accumulates, and compounds over time.

Now, let us look at some real-life examples of student loans and credit card debt.

Calculating Debt Interest

We will use the average student loan debt statistics from Credit.com, U.S. Average Student Loan Debt Statistics in 2019. A recent graduate has a total balance of $31,172 in student loans, with a fixed average interest rate of 5%, and a standard 10-year payment term.

Using the student loan calculator from Studentloanhero.com, it calculates the amount of interest that accrues. The calculator also provides an estimated monthly payment of $331 every month for the standard payment plan of 10 years.

So, if this recent grad paid $331 every month for the next 10 years, they would have paid $8,503 in interest to borrow the initial balance of $31,172. Tack that onto the initial balance; the total cost of the loan plus interest would be $39,675 for 10 years.

Daily Rate of Interest

Another way to calculate interest is by the daily rate of interest. Below are the steps from NerdWallet.com, which will help determine the cost to borrow money every single day. You can also use the student loan interest calculator to determine the interest that has accrued since the last payment. Keep in mind that the calculator does some rounding, so they are close estimates.

1. Calculate your daily interest rate (sometimes called interest rate factor). Divide your annual student loan interest rate by the number of days in the year. Note: some companies use 360 days per year.
   • .05%/365 = .00013699 or .013699%

2. Calculate the amount of interest your loan accrues per day. Multiply your outstanding loan balance by your daily interest rate.
   • $31,172 x .00013699 = $4.27025

3. Find your monthly interest payment. Multiply your daily interest amount by the number of days since your last payment.
   • $4.27025 x 30 = $128.1075

It cost us $4.27 a day to borrow the total amount of $31,172. If we did not make a payment for 30 days, we would multiply the daily interest rate by 30, resulting in $128.11 of interest for the month. The daily interest rate would decrease as we make payments and reduce the overall principal.

Accrual vs. Compound Interest

It is also important to understand the difference between accrual and compound interest. Compound interest is how much and how often the interest grows. Accrual, or accrued, is the total interest that is added back to the account balance.

In this example, student loan interest is usually compounded daily. So the compound interest would be the same as the daily interest rate of $4.27 per day. Other compound periods are monthly, quarterly, and annually.

Some wise advice from an article on compound interest from Bill Fay, “If you have a debt that uses compound interest, the amount you owe will grow each time the interest compounds and your payments will get larger over time. For that reason, it is wise to pay down compounding debts as quickly as you can.”

The accrued interest in this example would be $128.11 for 30 days. If we wanted to know the accrued interest for ‘X’ number of days, we would simply multiply the daily interest rate by the number of days since the last payment.

It’s a good idea to check with our loan providers to understand these details. It should be accessible on the company website, but if it’s not there, do not hesitate to email or give them a call. There are people there to help, it’s their job.

Looking ahead

Just as a point of reference, multiply $128.11 by 12 months and we’ll be paying roughly ~$1530-$1550 in interest for one year. Again, the total amount of interest will depend on how much and how often we make payments.

Image what we could do with an extra $1500 if we did not owe it to anyone? We could easily invest it to make money + time work for us, build an emergency fund to lessen the blow of a medical bill or car repair, fund a retirement account to get out of the rat race, improve our quality of life, start our dream business… the possibilities are truly endless.

How the Cycle Continues

Let’s look at another real-life example with credit cards.

In an article by Megan Leonhardy on CNBC.com, she mentions “the average credit card APR is at a record-breaking 17.57 percent.” Side note, this can easily be 2-8x higher than the interest rate of student loans. So if we were looking to make a dent in our overall debt, it would be wise to start eliminating consumer credit card debt as quickly as possible.

Megan goes on to quote industry analyst Ted Rossman who states “the average household with credit card debt owes roughly $5,700, while those under the age of 35 owe $5,808. If you only paid the minimum on a $5,000 debt at the current average interest rate, you’d be in debt for over 18 years and pay roughly $11,400 in interest.”

Let’s Break Down the Numbers:

Principal Balance: $5000

Average interest rate: 17.57%

Monthly Payment, minimum: $76.55

Time to payoff total balance: 18 years or 216 months

Interest: $11,491.77

Total cost: $ 11,491.77 + $5,000 = $16,491.77

Putting it into Perspective

By spending $5,000 and only paying the minimum balance every month, it would cost us a total of $16,491.77 and take 18 years to pay off. This scenario reflects the initial balance and assumes that we never use the credit card to purchase anything again. Let that sink in.

We are essentially agreeing to pay triple the amount for whatever it is that we could not afford and wanted so badly today. More than twice the amount is going straight to interest. It would take about two decades to pay off the amount assuming that we cut up the card, cancel the account, or never use it again.

The Mindless Use of Credit Cards

Why would anyone do that? Sadly enough, it happens more often than not. There has been no easier time to apply and get approved for a credit card than today. The rewards, offers, and opportunities are everywhere.

The worst part is that we skip through the terms and conditions. It has become an annoying obstacle in our way. We never go through the hassle to read or understand them. Once we are instantly approved, we go straight to swiping our cards.

Unlike cash or check, we don’t see or feel the physical transfer of money. We end up spending more than we typically would. It doesn’t hit us until the monthly statement and we are left scrambling with “too much month at the end of our money.”

Snowball Effect

So many of us continue to charge/finance things that we cannot afford. We end up only able to pay the minimum payment, which hardly makes a dent to pay off the total balance. Interest accumulates and our total debt increases.

As a result, we end up paying so much more money for things over and over again. It feels like a snowball rolling down an endless mountain, constantly growing in size. This is how the vicious cycle continues because we do not fully understand what it means to borrow money in advance.

The way to break the cycle is to start getting informed. By getting a good grasp of the basics, we’ll be able to apply our knowledge to any type of debt that we have incurred. From student loans, credit card debt, and mortgages, tackling each one will get easier and easier.

Conclusion:

Looking back, all of my stress and financial worries could have been lessened or prevented. Now, being more informed, I always think twice about how I spend my money. To prevent giving in to my wants vs. needs, I stop to question myself. Here are a few examples:

• Will this purchase pull me in or out of debt?
• Do I need this? Or do I simply want this?
• Will this increase or decrease the amount of time, energy, or happiness?
• How will this impact me from reaching my goals?
• What are the positive and/or negative consequences of this purchase?

Our lives change the moment we decided that we no longer wanted to live in debt. By simply educating ourselves, we can begin to create better habits and systems to obtain our goal.

So many financial decisions that we struggle with become crystal clear. As a result, we win back our valuable time, energy, and happiness. We clean out the clutter and focus on improving our quality of life.

In the end, we are the ones who suffer the consequences/pay the price of not understanding and figuring out our finances. Thankfully, we all have the freedom and capability to change that for ourselves.

If you have not done so, I encourage you to read “7 Stage of Financial Independence.” This provides insight into the different stages to identify where we are and where we want to go. Together, let’s begin the journey of bringing our intentions to life!

Let’s Talk:

Are you struggling with debt?

Or how did you overcome your debt situation?

I’d love to hear your feedback. Please leave a comment below. If you found this information helpful and know someone who could benefit, don’t hesitate to let them know and share this post with them!

Also, don’t forget to subscribe below!

[convertkit form=1205270]

Thank you so much for sharing your time and energy with me!