When you look at your finances, how do your debts make you feel? Are you satisfied with the way you are managing them, or do you think you can improve? Debt is one of those topics we don’t like to hear yet we know it affects us in one way or the other. When it comes to debt repayment, it is better you are in control and not, debt is in control of you.
A common misconception on the topic of debt is that all debt is bad. However, when it comes to building your wealth there can be good and bad debt. Good debt can be defined as debt that helps you generate income and increase your net worth. Bad debt, on the other hand, drains your finances and makes it hard to grow your wealth.
That being said, here are a few examples of good debt and bad debt and reasons and why they are classified as such:
Good Debt
- Business Loan – Obtaining a loan to begin a new business is considered as a good debt. Funding a business at the growth stage can be quite expensive, and this could end up straining you financially. A business loan taken at the onset can free up your personal income, and give you the extra motivation needed to take your business to the next level.
- Mortgage – Mortgage can be a good debt, especially if the property in question, will be rented out. It works in the following way, you identify a property in a location that could one day experience a rise in property values. You proceed to obtain a mortgage to buy the property and rent it. The rental payments will be an additional revenue stream while the property will appreciate in value.
- Student Loan – If you planning on growing your wealth, a good education will go a long way in helping you to achieve that. A student loan is regarded as a good debt since you are investing in your future with the possibility of positive returns in the long run. As long as you are studying a degree that leads to a career with opportunities, you shouldn’t shy away from taking a student loan, if you can’t afford the tuition fees.
Bad Debt
- Vehicle Loan – Usually, people take out this loan to buy a car which can allow you to move around conveniently, without experiencing the inconveniences of public transport.In addition, you can use it for family trips and social outings. However, a vehicle continuously depreciates after purchase and maintaining it is expensive. You are recommended to buy a cheap second-hand car to reduce costs or use it for income generating activities.
- Consumer loans – Consumer loans are a common form of debt taken out by individuals. The loans can be used to buy televisions, furniture, going on holiday etc. If you want to build your portfolio then taking debt to spend on such luxuries needs to be avoided. Remember, if you can’t pay for it in cash, then you can’t afford it!
- Real Estate – In the ‘Good debt’ section we have listed taking out a mortgage for buying a rental property, as a viable option. However, using it to buy a house for you to live in has very little financial upside. By buying that large house through a mortgage, your money will be tied up in mortgage payments and home improvements and maintenance. This means you will have precious little left for investment or income generating activities. Mortgages are one of the reasons why people are stuck in dead-end jobs with limited prospects for financial advancement.
Now that we know what good and debts are, the next step is figuring a way to clear your debts. Generally, as a rule, when it comes to managing debts, you either spend less or earn more. Whatever extra money you have should go towards servicing your debts. Below we will discuss 2 main debt repayment options that can aggressively reduce your debts.
Debt Repayment Options
The two debt repayment plan include the avalanche method and snowball method. Each option has its own advantages and it’s up to you to decide which one is best for you.
Snowball method
For most people, paying debts with the largest interest component is the usual way of handling debts. Their justification for this is, in the long run, they save hundreds, if not thousands on interest payments. Also, it makes the most sense mathematically. The drawback is personal finance is 20% head knowledge and 80% emotion.
Usually, debtors need to feel a sense of achievement if they are to stick to their debt reduction goals. Nothing can be motivating to a debtor like multiple small wins as opposed to a single large win. The Debt Snowball method encourages people with debts to pay their least credit balance. You direct the maximum amount you can afford to pay (without defaulting on your other debts and bills) to your lowest balance. In the meantime, the minimum due on all other debt balances, have to be paid.
Once the first credit balance is fully paid off, you move to the next smallest debt balance you owe. This time around you will be able to roll off the amount allocated to the former debt, on the new payment. Using these approach, you can slowly work your way up the list, freeing up funds to tackle the major debts. In the end, you will have succeeded in paying off your debts in a few years and can now start growing your wealth.
For example, you have a business loan of Ksh. 50,000 at 14% interest, and a student loan of Ksh. 26,000 at 4%. Paying the business loan amount fully can take you years, and somewhere along the way, you may fall off the bandwagon. During this period, you may realize that yearning for an accomplishment is what gives you the motivation to stick to your plan. You may prefer to diligently pay off the lesser amount of Ksh. 26,000 and with the morale boost, start paying down the Ksh. 50,000 balance.
Avalanche Method
The basic idea of the Avalanche method is almost similar to the snowball method, mentioned above. Once you are done paying off one debt, you put the extra cash to another debt payment. The difference is since you are beginning with your most costly debt, each payment you make brings you closer to a debt free future. So, instead of paying your smaller debt balances and going upwards, avalanche method involves paying off the account with the highest interest rate. Once that is cleared you move to the account with the second highest interest rate and repeat the same process.
Let’s say you have the following accounts and you are using this method to clear your debts:
Account 1: Ksh. 97,000 – 10.99%
Account 2: Ksh. 9,000 – 5.99%
Account 3: Ksh. 35,000 – 14.00%
Account 4: Ksh. 50,000 – 8.99%
In the avalanche method, you start by listing all your debts in descending order from the highest interest balance to the least. Therefore, the above accounts will look like this:
Account 3: Ksh. 35,000 – 14.00%
Account 1: Ksh. 97,000 – 10.99%
Account 4: Ksh. 50,000 – 8.99%
Account 2: Ksh. 9,000 – 5.99%
By taking out the highest interest rate balance first, you are saving the difference in percentage rate from one balance to another. Just like the snowball method, you add any extra funds you have to settle account 3, and once that is done you use the money set aside for that account, plus the surplus to tackle account 1 on the list. By working through your debt in descending order you will take the least amount clearing the debt.
Verdict
While many people may debate which of the two options is effective, the only you should think about is clearing your debt. It really doesn’t matter which plan you use, as long as it works for you! Remember, your interest balances will not stop accumulating while you sit down and compare plans.
You can use a combination of both snowball and avalanche methods. For instance, you pay off your small debts in the beginning and with the momentum you have gained switch to paying down the largest interest balance. Whether it is loans or credit cards, you can use either method to work around the system and improve your credit rating.
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