Pay Off Your Debts

-Publilius Syrus

YOU ARE NOW ready to begin building a plan to eliminate your debt and start building real wealth. Everyone is different, and there is no one path to a wealthy life. But if you’ve followed the first three steps, you should have accomplished the following:

  1. Destroyed your credit cards and stopped adding any new debts.
  2. Completed a personal financial inventory to determine where your money comes from and where it goes.
  3. Started saving at least 10 percent of your take-home pay, which has:
  1. Built your one-month cash buffer.
  2. Created 10 percent free cash flow in your budget.

With a little money put aside for emergencies and 10 percent of your monthly income freed up, you’re ready to start eliminating your debts. There are many approaches to paying off debts, and some get pretty complicated. My approach is very simple and logical. We’re going to prioritize our debts and then focus all our attention on paying off the first one on the list. When the first debt is paid off, we’re going to turn our attention to the next one and do the same thing. Then we’re going to keep repeating that simple process until there are no more debts on the list. Finally, we’re going to turn our attention to our mortgage and get rid of that debt, too.

Every expert I’ve ever heard talk about eliminating debt has taught this approach or a slight variation of it. That nearly universal agreement around this approach is the best evidence that it’s the approach to take if you really want to get out of debt. Why is everyone in agreement? Because this strategy is simple and it works. I wish I had a fancy name I could call this strategy, but the best I could do is the debt roll-down strategy. There may be a few things you could do differently that might save a dollar here or there, but I choose to err on the side of simplicity and clear, measurable progress. Each day of following your debt elimination plan is a small victory on your road to success.

I’ve learned in business and personal finance that success breeds success. If you don’t see any pounds dropping when you step on the scale in the morning, it’s going to be hard to stick to the diet when you head to the kitchen to make breakfast. We need constant daily and weekly victories to remind us that we’re making progress toward our goal of a debt-free and wealthy life.

I played lots of sports in my youth. I played baseball in the spring and summer, football in the fall, and basketball in the winter. Sports were a big part of my life, and I learned many valuable life lessons in my experiences on the playing field. Even if you’re not an athlete and have never participated in sports, I’ll bet you’ve heard the cliché, “Take one game at a time.” That cliché is probably the most overused saying in all of sports. Coaches tell their players to focus their attention on the next game and to not think ahead to a future opponent, or they may get beat. It happens all the time. A team wins a few games and starts thinking about winning a championship, and then they get upset by a mediocre team before they even get to the championship game.

When it comes to winning the debt game, we need to focus all our efforts and resources on one debt at a time to eliminate it completely, and then turn our full attention to the next debt until all of our debts are gone.

In this step we’re first going to rank our debts, with the exception of your mortgage (if you have one), in order of importance and execute the debt roll-down strategy to pay them all off as quickly as possible. You’ll be able to see your progress every step of the way. Your debts will quickly begin to melt away right before your very eyes.

To help you see exactly how to implement this strategy, I’m going to create a model couple and walk you through the steps of executing the debt roll-down plan. We’ll call our model couple Joe and Mary Smith. And here are their current financial details:

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Now you need to prioritize your debts in the order you’re going to attack them. There are differing schools of thoughts here, so let me share my personal view. As I mentioned earlier, I like to have frequent victories. I also realize the key to rapid debt elimination is to free up more and more cash flow in my budget so I have more discretionary money to pay toward the next debt on my list.

There are two primary schools of thought on prioritizing debt. The first is to start with the smallest debt and move to the largest debt. I like to prioritize the debts by taking both the balance and the minimum payment into consideration. If you divide the current balance by the minimum monthly payment, you’ll get a number for each debt that correlates approximately to the number of months remaining until the balance will be paid off. I like to use this number as a common denominator to prioritize my debts for payoff. Start with the lowest number at the top of the list and move down in order to the highest at the bottom.

I’m not going to turn this into a math class, so let’s just say that either approach will work fine as long as you focus all your resources on paying off one debt at a time until it’s gone. I believe the math favors the common denominator approach, but it’s what motivates you that matters most.

The primary objective is to pay off one debt at a time to increase your free monthly cash flow so you have more money to apply to the next debt on your list. The size of the minimum payment you eliminate with each retired debt is more critical to increasing free cash flow than the size of the interest rate on the debt. That may seem counterintuitive, but it’s true. I just know that if you start with the biggest debt first, you may get frustrated at the lack of progress and stop working the debt roll-down strategy altogether. As I said earlier, success breeds success, so consistent, regular victories make it easier to stay the course.

Here’s Joe and Mary’s debts ranked using the smallest to largest approach:

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Here’s their priority list ranked by dividing the balance by the minimum payment:

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Now you’re ready to prioritize your own debts so you can start the debt roll-down process. Use the blank form below to build and rank your list.

Debt Register
Current Debt Current Balance MinimumPayment Balance/Payment Priority Ranking


EXECUTING THE DEBT ROLL-DOWN STRATEGY

Now that you’ve organized and prioritized your debts, you’re ready to start paying them off. Start with the first debt in your list, and begin to pay the minimum monthly payment plus your 10 percent free cash flow toward that one debt. While you focus your attention on this one debt, you should continue to make the minimum monthly payment on all your remaining debts to stay current on them.

Once you retire a debt, you roll down to the next debt on your list and begin the same process, with one addition. Each time you retire a debt, you free up more cash flow in your budget to apply an even larger amount of discretionary money to the next debt on your list. You make the minimum monthly payment plus your 10 percent free cash flow plus the payment from the debt you just retired. The new payment for the next debt on your list gets bigger with each debt you retire. Even though the size of the minimum payment may shrink as you pay down the balance, keep the payment the same as it was at the outset, no matter what.

Let’s take a look at Joe and Mary Smith’s debts to see how this would work, using the smallest to the largest ranking approach.


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Notice how quickly the size of their payments grows as a result of the additional free cash flow that is created by paying off each debt. It’s pretty easy to see that the time needed to retire each debt with this new, larger payment will be a fraction of the original time it would take making just the minimum required payments. Now you’re starting to see the magic of the debt roll-down strategy at work.

Following this simple plan, Joe and Mary will retire all of these debts— nearly $60,000 of them—in less than three years and free up over $2,000 per month in their family budget. The impact on their life will be dramatic, with a 25 percent increase in their monthly cash flow from what it was when they were buried in debt. Most people can cut years off their debt payoff schedule by following this simple, proven strategy. They will see quick results as they knock off each debt from their priority list, which will in turn motivate them to stay the course.

So now it’s your turn. Use the form below or create your own in your word processor or spreadsheet to determine the new payment for the first debt on your personal debt priority list. Now start making that new payment amount toward that debt immediately and continue until it’s gone. Then move to the next debt on your list and add the old payment from the debt you just paid off to your free cash flow and combine it with the minimum payment to get the new payment for that debt. Each time you pay off another debt, roll the old payment amount down to the next debt on the list to get a new, larger payment amount.

Debt Register
Current Debts Current Balance Current Payment Priority Ranking Free Cash Flow New Payment

I can assure you that when you begin to see your debts melt away at an ever-increasing clip, you’re going to begin to taste the joy that comes from being in control of your money. Enjoy it and crave more of it, so you will stay the course. There are still more sacrifices to make, but you’re well on your way to living a debt-free and wealthy life.

Now that you’ve mastered the debt roll-down strategy to retire all your consumer debts, you’re ready to begin accelerating the payoff of what is most likely your largest debt, your mortgage. If you don’t have a mortgage and you’ve retired all your consumer debt, you’re ready to begin putting that new free cash flow to work to start quickly building wealth for your retirement.

PAY OFF YOUR MORTGAGE

I’m sure you’ve heard the saying, “There are two types of people—those who pay interest and those who collect it.” Borrowing money has been around since the beginning of time. Depending on which of the two categories of people you fall into, you see interest as a great source of income or a huge burden you carry.

For most people the single largest debt they will have in their life is for a home. I believe that a house is one of the few things it’s okay to borrow money for. The key difference between my view of a house and that of society as a whole is that I look at a mortgage as a short-term debt rather than a life-long one, as most people do.

It’s amazing to me how quickly views have changed regarding debt. For my father’s generation, paying off the mortgage was one of the crowning financial achievements in life. If you were able to pay off your home, you were considered wise and successful by nearly everyone. My father worked hard to pay off his home and saw that as a significant financial achievement. In many cases, people of his generation would have a party when the mortgage was paid off, during which they would burn all the papers associated with their now-retired debt.

When I look at my own generation in contrast with my father’s, I see some very dramatic differences. I hardly know anyone in my generation who has a plan to pay off his or her mortgage anytime soon. Indeed, most have resigned themselves to the “fact” that they will have a house payment for the rest of their lives. It’s their largest single monthly payment, with their entire financial life built around what’s left over each month after they make the house payment. And yet they have no intention of ridding themselves of the burden.

It’s my generation that created the credit mess we’re dealing with right now. I personally know dozens of people who purchased or refinanced their house with a 100-125 percent mortgage and pulled some or all of the equity out of their home to spend on a lifestyle upgrade. (Hey, they “needed” a furniture upgrade to match the house upgrade, and it wouldn’t be right not to have a nice new European sports car—or two—in the garage to complete the picture.)

What’s even worse is that many of the people who took advantage of the loose lending practices of the banking industry also chose the adjustable rates loans and the interest-only payments. Now that home prices have corrected and interest rates have adjusted, they are living in a house with negative equity, with a house payment that is two to three times what it was when they started and a lifestyle they simply can no longer afford. It’s a tough picture, but a common one these days.

Call me old school, but I agree with my dad that there is tremendous value in paying off your house. Many wealthy people I know don’t have a mortgage, and I know they love the fact that they have a huge chunk of extra cash flow they can use to sustain their comfortable lifestyles and enjoy life. I’m convinced that most people just accept the “old way” of dealing with a mortgage because they don’t know any different or better. That’s about to change.

I’m not talking here about another expensive refinance program or a bi-weekly payment plan, as such approaches are too complicated and too expensive for the little benefit they provide. Instead, I’m going to show you how, by following the simple debt roll-down strategy you learned in the last chapter, you can pay off your home, in as little as 7-10 years, or less, using nothing more than your current income.

Life for most people would be dramatically different if they didn’t have a mortgage payment to make. They would free up a ton of cash flow to use for retirement savings or lifestyle enhancements without adding to their debt. It’s possible, and I’m going to show you how to do it in this chapter. If you followed the debt roll-down strategy we taught you in the last chapter, you’re going to have a lot of free cash flow once that last debt has been paid off.

Let’s go back to our example with John and Mary Smith. They had a total of $58,800 in consumer debt. Using the debt roll-down strategy, they were able to pay off all their debts in just under three years. This freed up an additional $2,040 in cash flow each month in their budget. Now let’s take this example on step farther and factor their first mortgage into the equation.

Joe and Mary owe $170,000 on their first mortgage. The interest rate on the loan is 6.5 percent, and they make a payment of $1,600 each month. At their present rate, they would need another 28 years to retire this debt. Let’s apply the debt roll-down strategy and see how much time and money they could save.

If they apply the free cash flow ($2,040) created by paying off all their other debts to their minimum monthly mortgage payment and stick with that amount going forward, they will retire their entire $170,000 mortgage in another three years and nine months. That’s amazing!

Counting all their consumer debt as well as their mortgage, Joe and Mary have paid off over $227,000 in debts in six years and nine months. That’s more than 20 years faster than if they had done nothing and continued to make the minimum monthly payments on their debts. On top of that they will have saved in excess of $60,000 in interest payments over that time. That’s money that can now be applied to the second part of the process, becoming wealthy.

This example is not too different from the situation many of you are probably in. Imagine being able to be totally debt-free in less than seven years, using nothing more than your current income. It’s totally possible if you follow my 60-Day Money Miracle plan.

This is not the only way to retire a mortgage, but it’s the easiest and surest way I know of; and you don’t need any special knowledge or tools to do it. You have everything you need right in your hands with this book. Now let’s take a look at some of the other common methods for paying off mortgage debt.

OTHER MORTGAGE PAYOFF OPTIONS

We’re constantly bombarded with offers to refinance or change the way we manage our debt. I thought it would be helpful to review a few of the most common approaches to paying off your mortgage debt so that you can be better informed and make a wise decision, given your own situation.

Bi-weekly Mortgages – By making half a payment every two weeks, you will end up making one additional payment per year on the mortgage. This will typically reduce the time it takes to pay off your 30-year mortgage by about 3-6 years on average. Instead of making 12 monthly payments, you make 26 half payments. That works out to 13 total payments on your mortgage each year. This is a viable solution when there is no other option to accelerate mortgage debt and can be a good solution for people who struggle with budgeting their money. The disadvantage of the bi-weekly mortgage is that you have to remember to make your payments on time or you lose the benefits of paying the extra money. There are companies that will provide automatic payments for a fee, or you can simply do this on your own and save some money. This approach works, but it can be complicated if you don’t stay on top of it or if you forget to plan for that extra payment.

Shorter-term Mortgages – There are other mortgage products that have shorter terms such as the 25, 20, or 15-year loans. It makes good sense to get a 15-year mortgage instead of a 30-year mortgage, if possible. You will save a lot of interest and will be debt-free in half the time. However, because the term is so much shorter than a 30-year loan, the scheduled monthly payments are much higher. If your cash flow requirements change due to loss of job or an unexpected financial shortfall, those higher payments can be difficult to deal with. There is little or no flexibility with these loans if your cash flow situation changes.

Extra Principal Payments – Most mortgages allow you to make additional payments to principal anytime you want without penalty. An extra $5,000 paid toward the principal of a $250,000 mortgage on a 30-year term would result in a savings of over $28,000 in interest over the life of the loan. That’s almost six times your money in interest saved. That’s a great return in my book. This approach is a great way to shave years off your mortgage and thousands off your interest expenses.

If you have a 30-year mortgage, you could choose to send in a little extra money with your regular monthly payment and have it be applied directly to the principal of your loan. The problem with this approach is that it requires “extra” money over and above your regular mortgage payment. That’s extra money that most people simply don’t have.

There is also a real fear of “what if I need that money back in an emergency,” and that fear is justified. Once you pay money into a mortgage, which is a closed-end loan, you can’t get access to that money again unless you refinance. When times are tough and you need the money the most, like if you lose a job or you’re hit with an emergency, the bank may not be too willing to let you get at your equity.

Common sense will tell you that sending extra money to pay your mortgage principal will save you some interest, but most of us are not sophisticated enough to determine exactly what that impact or benefit is so we can compare it to other investment opportunities. Sure, sending more money to the mortgage company is a good thing, but just how good? What are the effects? How can I use those changes to my advantage? Measuring the impact of financial decisions on your entire financial picture is key. If you can’t measure the impact or benefit, how do you know exactly where you are in relation to your debt reduction goals? How do you know if you need to make “course corrections” to get back on track with your goals? Oftentimes, people lose focus when they can’t see the fruits of their efforts. It is difficult to stay on target when you can’t see or don’t really know what the target is!

Refinancing pitfalls – Many people think the answer to their debt problem is to simply refinance high credit card balances or a high-interest mortgage into a new lower-rate mortgage. I have many friends in the mortgage business that made a killing over the past 10 years helping people refinance their homes multiple times. Each time the rates would drop, my friends would go back to their clients and show them the new lower payment or cash they could pull out of their home, and the clients would instantly refinance. I know some people who refinanced the same home three or four times over the past decade. Although there can be advantages to refinancing, far too often the costs offset the benefits. If you’re not sophisticated in these things, you’re easy prey for predatory lenders.

The most obvious benefit or motivation for refinancing is often an increase of monthly cash flow from consolidating debts or lowering your interest rate. Unfortunately, the bad habits that got you into debt in the first place have not been addressed, and most people who refinance for this reason quickly find themselves right back in the same situation, but with a new, larger loan on their home.

Every time you refinance your mortgage, the mortgage clock starts at zero all over again, rendering all the scheduled monthly payments you made to that point a wasted effort. The thing most homeowners fail to recognize is that it’s not about the rate, it’s about time. The longer you carry debt, the more interest you will pay, even if you compare against a lower interest rate. It often takes years to make up the costs of refinancing to a lower rate. If you don’t plan to stay in your home for that entire period of time, you’re going to lose the benefit of refinancing.

Here is an example:

Let’s say you bought a home, and the loan looked like this:

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If you stay in the home and pay off the loan in 30 years, you will pay $255,090.48 in interest charges. That’s after paying off the principle—or more than double the price of your house. Let’s assume that three years after you purchased the house, the rates drop by 0.5% (from 6.5% to 6.0%) and you decide to refinance. Let’s see how this refinance will impact your situation.

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If you stay in your home and pay off this loan in 30 years, you will pay $228,202.37 in interest charges. That looks like a $30,000 savings from the first loan, right? Wrong. After three years of paying on that old 30 year loan, you will have already paid $38,343.39 in interest, which means you will pay 38,343.39 + $228,202.37 = $266.545.76. That’s $11,000 more interest overall, even with a .5% lower interest rate. On top of that, you have pushed out the repayment of the debt by three years, which means you will lose out on three years of potential investment time with the money you are paying to your mortgage company. You are basically trading a small monthly savings in your payment of about $80 for three years of retirement and investment growth. What is refinancing really costing you?

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Counting the $11,000 in extra interest you’re going to pay, that’s a $62,000 swing in the wrong direction!

Understanding the effects of every financial decision you make is essential in becoming debt-free and wealthy. And given that your home is your most important—and most expensive—asset, you need to pay close attention to what that roof over your head is actually costing you.