Okay, so you’re buried in debt, have a steady income stream, and after reading Why Can’t I Be Rich, Part 1 (Cutting Down Expenses) along with Jacob’s 21-Day Makeover at www.earlyretirementextreme.com, you’ve improved your cash flow. Now what?

Part 2- Paying Down Debt

Before you focus on paying down debts aggressively, you’ll need to establish a way to pay for emergencies; things like an unexpected medical bill or house or car repair (we’re not talking about an end of year clearance on this great pair of shoes or home theater system you’ve been wanting!). The three easiest choices for this are usually a credit card, a home equity line of credit (HELOC) if you own property, and if you have a 401k plan, you typically have the option to borrow against it. Remember, we’re talking about emergency use only. Beyond these options, consider a parent or other family member that may be willing to help, ONLY in the event of an emergency. Family will likely be more willing to help if they know you’ve made changes to improve cash flow and are focused on paying down debt, so be prepared to share your income and expenses if you’re going to ask someone for emergency backup funds. Just like a bank, people want to know you have a means to pay back money if you ask to borrow it!

A lot of people might prefer to save up a couple months worth of cash on hand for emergencies instead of borrowing, but this would be at the very bottom of my list. It simply makes better financial sense to NOT hold cash because it depreciates at the rate of inflation (as costs of things go up, the value of your cash on hand goes down), and while you’re losing the value of your cash on-hand, you’re continuing to hemorrhage money as interest payments on your outstanding debt. For this same reason, you shouldn’t take the time to try and save for emergencies. How long will this take and how much do you even need? Nobody knows this answer, so while you’re saving and trying to predict how long you need to save, again, you’re continuing to hemorrhage money for whatever time it takes… months, years?!

Once you have an emergency plan, make a list of all outstanding debts including credit cards, student loans, mortgages, car loans, and anything else that you’re paying back on installments or borrowed money. Find out the interest rate on each debt you currently have and organize them from highest (usually credit cards) to lowest (usually student loans or mortgages). This is your priority order for paying down debts. And before attacking these debts, make sure to take some time to consider if the item(s) purchased on credit are necessary, and if not, sell! Even if you’re upside down on a debt, consider selling! You need a tourniquet to stop the bleed, not a damn Band Aid! They’ll be plenty of time and money to buy replacements once your finances are under control.

Starting with your highest interest rate debt, pay every last dollar you can afford on that debt while paying the minimum due on every other debt. In doing this, you are applying the most money you have available to the debt that costs you the most money in interest. Some people are uncomfortable with having no cash reserves for an emergency, but trust me, your interest bearing debt IS an emergency, and besides, you should have an emergency plan! Once your highest interest rate debt is paid off, move to the next highest interest rate on your list, and keep going until all interest bearing debt is paid off. Well, at least all interest bearing debt that exceeds expected stock market returns. More on this in a bit.

Measures to Accelerate Paying Off Debt

– New credit card (CC) with 0% balance transfer – This is my absolute favorite method because you can use new unsecured credit to pay off old unsecured debt while also reducing interest rates. You can apply for as many offers as needed to transfer all of your higher interest debt to 0%. Most new credit card offers with 0% balance transfers usually do not charge up front fees, but you should confirm this before applying to each. NerdWallet maintains a list of current offers here: https://www.nerdwallet.com/best/credit-cards/balance-transfer (I am NOT affiliated, nor do I get any commission from NerdWallet or the listed CC companies). If you go this route, use the new CC to transfer your highest interest rate debts to 0%, and then start maximizing what you pay on your remaining highest interest rate debt.

Keep in mind that you can transfer balances from multiple CCs onto one new one, assuming you have sufficient credit available. For example, if you already have a Mastercard with $1000 balance at 19% interest and a Visa card with a $2500 balance at 17% interest, and you are accepted for a new CC with a $3000 limit and 0% introductory offer for 18 months; you could (and should) transfer all of the Mastercard’s $1000 balance plus $2000 of the Visa card balance to the new 0% card, then begin paying the last $500 of your Visa remaining at 17% the most aggressively. If you use this method, make sure you always make minimum payments on time since missing a payment can eliminate the 0% introductory offer and switch to a much higher rate like 15%, 20%, or more. Many banks and CC companies allow setup of automatic minimum monthly payments, and I’d highly recommend doing this to make sure you don’t miss one!

– Existing credit cards with 0% balance transfer offers –

As noted above, if you’re not able to secure enough new CCs with 0% balance transfers and $0 fees, you can check with your existing CC companies (assuming you have credit available) for a 0% balance transfer offer. As noted above, these typically come with a balance transfer fee of 3-5%, but depending on the amount of debt you have and how long it will take to pay it off, that 3-5% is probably worth it as it gives you time to make minimum payments at 0% interest while you to attack other higher interest rate debts. Do some quick math assuming simple interest to gauge if it’s worth it: for example, let’s say your highest interest rate CC has a $3000 balance at 17%. Assume that with your monthly cash flow (income minus expenses), you calculate this will take 6 months to pay off. You would be better off to move this to a 0% balance transfer offer even if it meant paying a 5% up-front fee since this cost less than paying 17% for 6 months (17% / 2 = 8.5%). No, CC companies don’t use simple annual interest like this, it’s actually compounded daily; but this order of magnitude calculation is close enough!

– Home Equity Line of Credit (HELOC) –

This option is a double edged sword. First the bad: if you use a HELOC to pay off credit card (unsecured) debt, you’re putting your house on the line when it’s not necessary to take that risk. The other bad side is I’ve heard stories about some folks using home equity to pay off credit cards, only to turn around and run up credit card debt again while still paying the HELOC! Don’t be this person! Now the potential good: if you have equity in your home and can go this route, you may greatly reduce the typically high interest rates you’d pay with credit cards, reduce the total amount you’ll pay on that outstanding debt, greatly simplify your repayment of money you’ve borrowed, be able to pay only a much lower minimum in case an emergency limits your cash flow temporarily, and most likely be able to write off the interest paid on the HELOC debt when it comes tax time. Check with your tax professional regarding interest paid on a HELOC, but the last time I checked, my understanding was that up to $100k of a HELOC’s interest could be used as a tax writeoff without proving the money was used for home repair or improvements.

– Borrow against a 401k –

If the HELOC option didn’t make your butt clench, this one just might! Again, leading with the bad: taking money from your 401k takes away the opportunity cost of adding to your retirement savings. Let’s say for example the market is average and gaining around 8% per year. Theoretically, any money taken out of your 401k should be used only if needed to pay interest rates above 8%, but in practice, nobody has an accurate crystal ball to predict where the market is going. What if you pull money out to pay off 15% credit card interest debt, only to watch the market skyrocket over the next few months and return 30%? In the past, I’ve considered the odds and made an educated decision based on historical market returns of 8%. I would never pull money out of a 401k if you’re in a market crash or downturn; nobody wants to buy high and sell low! Another huge negative consideration is what if you lose your job suddenly? At least some plans require that you pay back the full loan amount within a few months, and you should be aware of your plan’s rules if you’re going to consider this and come up with a plan to pay back quickly if needed. This may be as simple as writing a check from the credit card account that you originally paid off with the 401k loan, but have a plan.

With all this bad, there is some good. Money that you borrow from your 401k is paid back with interest, and that interest also goes back into your 401k. Another positive was eluded to above; if the market is between flat and average performance, it may make sense to pay off all high interest debt in one big swoop (assuming you’ve saved enough in your 401k to cover those debts) and start focusing on investing right away.

So how long should you focus on debts before transferring to an investing strategy? Since nobody has an accurate crystal ball, again, I’ve considered the average of 8% per year returns in the stock market as a break point. Anything above 8% interest needs to go away immediately and anything below can be balanced against investments. Given this, (since 2007) I’ve treated our higher interest debt such as credit cards like a pants on fire event and did everything possible to eliminate those ASAP! Student loans and mortgages have some tax advantages, and in my experience, these have typically been under 5% interest, so I’ve balanced paying those down while also investing.

I’d love to hear from you in the comments if you’ve used these or other strategies to quickly pay down debt, and I’ll share how the Mrs and I attacked our debt problems in an upcoming My Journey post.

Coming Soon – Part 3, Investing