Category: Financial Literacy

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Financial Literacy

The Fastest Way To Pay Down Debt

If you have several outstanding loans, what’s the fastest way to pay them down? How should you prioritize which loan to pay down first?

The most efficient way to pay down existing debt burden is better known as the debt avalanche method.

It goes like this:

  1. Make an inventory of all the debt you have and their associated interest rate.
  2. Keep paying the minimum payment on all debt to avoid any fees and deteriorate your credit score.
  3. Focus on one loan at a time and make an extra payment on the loan that has the highest interest rate. Keep doing it until the loan is paid.
  4. Congratulations, you now have one loan paid off. Move to the next highest interest rate loan and use the extra cash freed from the minimum payment of the loan you just paid to pay this second loan even faster.
  5. Rinse, repeat, until you do not have any more outstanding debt, paying each loan faster by redirecting the extra cash from each paid off loan towards paying the next one.

This strategy minimizes the amount of interest you pay by targeting the loans with the highest interest rates first.

Some argue that in the battle towards paying off debt, the psychological aspect may be more important as it is often a marathon more than a sprint. And therefore seeking early sign of encouragement may go a long way to stay on the path of debt freedom.

In that regards the debt snowball approach is sometimes considered. The principle is similar to the debt avalanche method but instead of focusing on the loan with the highest interest rate, you’d focus on the loan with the smallest balance. So you more quickly scratch a loan off your list as an early encouragement.

However Mr. Honu is way too cartesian to allow extra interest payment to run and would focus on the debt avalanche method instead. But that’s just me. The debt snowball can be a decent alternative and is certainly better than letting your debt run away.

There are more resources on the debt avalanche and the debt snowball on the internet.

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Financial Literacy

Is Debt Bad and Should It Be Avoided at All Costs?

If you have some debt, should you pay it first or should you try to invest your way out of it? Is debt good or bad?

Generally speaking and as noticed in the “defining asset vs liability” post, debt is not inherently good or bad, it’s mostly about how it’s used. At the end of the day, debt is just leverage and you pay a premium to use that leverage in the form of interests.

Therefore, from an economic perspective, it usually only makes sense to use this leverage if the benefit of this leverage outweighs the cost of the premium. More simply said, if you borrow money at 5% per year and you’re pretty sure you’ll make a 10% or 20% return on that borrowed money it’s certainly worth it. However if the returns were only 3%, the cost of the debt would be higher than what you’d earn and it would probably not make sense from an economic standpoint to contract such loan.

So in the end, using debt to acquire cash flow performing assets is definitely worth it if the returns are higher than the cost of servicing the debt. But otherwise it should be avoided. Using debt for regular consumption is probably the worse type of debt one can contract, since the returns on consumption items are usually 0%: that new appliance or that fancy dinner will not make you any money.

A note on education: the current outstanding student loan debt in the US is now over $1.6 trillion. And many people are stuck in a job that does not allow them to service their student debt burden. Worse, as of January 2020, student debt is not dischargeable in bankruptcy and you may be stuck with your student debt for life. So for any student looking for a student loan, it’s probably wise to check what’s the salary one can expect out of college to assess how much debt is reasonable.

There are several websites to check how much one can expect for a given job:

Having, let’s say, $50,000 of debt out of Med school to be a physician is probably reasonable, ditto with a Computer Science degree to be employed as a software engineer (at least in early 2020), as these jobs tend to earn at least six figures out of college, but it is not the case for many other degrees.

It may all sounds like common sense, but it’s important to absorb and never forget the fundamental economic mechanics of debt, because it’s easy to get tempted by a fancy new appliance, house or college degree that could put an enormous drag on your finances and delay your financial freedom by several years if not forever.

But what if you already have debt? Should you pay it first or invest your way out of it? Well, every investment carries some risk and the money invested can be completely lost. On the other hand, the debt you pay down, is a guaranteed balance payment you won’t have to service anymore. Therefore, it’s usually more advantageous to pay down existing consumer/student loan debt.

But debt at the end of the day is leverage, and leverage carries risk. And carrying risk over an extended period of time is something to be dealt with carefully.

So, how should you go about paying it off? Have a look at the Fastest Way To Pay Down Debt.

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Financial Literacy

The Power Of Compounding

If you have $10,000 and you earn a 7% interest per year on it, you’ll end up with $10,700 at the end of the year:

10,000 + 10,000 x 7/100 = 10,700

And if you reinvest the profits, these $10,700 at 7% will become $11,449 the next year, and so on and so forth. You get the idea.

And while it does not seem like much it quickly adds up over time. Here is a chart of $10,000 at 7% compounded 50 times.

$10,000 with a 7% return

Now you may say that $280,000 is still not much over 50 years. But keep it mind, that it’s just money growing: you didn’t spend any time or any effort yet, it’s just $10,000 that you watched grow.

Now imagine that you’re able to save $5,000 a year and you invest them.

$10,000 with a 7% return, saving another $5,000

You’ll now cross the 1 million dollars mark after 40 years and you’ll get over 2 million dollars after 50 years.

And what if you’re able to save $10,000 a year?

$10,000 with a 7% return, saving another $10,000

You’ll cross the 1 million dollars mark after 31 years, and over 4 million dollars after 50 years.

Now these charts look the same but the scale is very different, when compared to one another:

And that’s how people get rich. It’s not by earning a higher salary which has barely changed for the average US worker in past 50 years, but by investing and reinvesting the profits, also known as compounding.

That fantastic power is unfortunately one of the most underappreciated and as Dr. Albert A. Bartlett puts it, “The greatest shortcoming of the human race is our inability to understand the exponential function“.

Now, the 7% growth rate is not completely innocent. It’s give or take, the average growth rate of the stock market in the past 100 years or so and we’ll get to that in another post.

To have a better grasp of the power and the sometimes dramatic implications of an exponential growth rate, I highly recommend the exponential growth arithmetic lecture from Dr. Albert A. Bartlett.

Who said education was expensive? Like most things in life, the best ones are often free. 😜

As a closing note, let’s be honest, saving $10,000 a year on a minimum wage will be close to impossible, unless you live with your parents. It will probably take at least a $50,000 income to be able to comfortably save $10,000 a year, depending upon the cost of living in your area, the number of dependents you have and your spending habits. And yes it represents a 20% saving rate which may seem high for some, but if you’re on a quest towards financial independence this is the minimum target you’d want to aim for. More on this to come soon.

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Financial Literacy

Defining Asset vs Liability

Money is just another problem that needs to be solved. And to understand a problem it is critical to define it properly. Albert Einstein famously said: “If I had an hour to solve a problem I’d spend 55 minutes thinking about the problem and five minutes thinking about solutions.”

And at the core of every problem definition lies the vocabulary and the true meaning of words. One of the greatest tragedy in modern age is not being able to properly define asset and liability.

So let’s keep this simple:

  • an Asset puts money in your pocket
  • a Liability takes money out of your pocket

Now if you’ve ever applied for a loan to buy a home, you may have stumbled upon a banker lauding how great of an asset your home is. Spoiler alert: it’s not. Or more precisely not for you.

Let me explain, to enjoy your home you’ll probably have to pay your mortgage, which takes money out of your pocket. You also have to pay property taxes which also takes money out of your pocket. You’ll need a home insurance, which again takes money out of your pocket. You’ll also need to cover expenses associated with maintaining your home, which yet again takes money out of you pocket. How much money does your home put in your pocket? $0. So from your perspective, your home is a liability not an asset.

Now looking at it from your banker’s perspective, the mortgage interests you pay on your loan brings money in your banker’s pocket. Therefore from your banker’s point of view, your home is an asset.

And with this comes an important corollary around assets and liabilities: the nature of a given resource usually does not define whether it is an asset or not. Instead the usage of such resource defines whether it’s an asset or not.

As seen with your home: it is a liability for you, but the exact same home is an asset for your banker.

Similarly if you own a rental property, which is just another home, and you make a profit after paying your mortgage and the associated expenses, then the rental property is an asset, because it puts money in your pocket.

Note that by integrating an investment component to your housing, you can limit or even sometimes eliminate the liability. And since the housing cost is usually the biggest household income for most people it’s well worth taking a hard look at it. See what house hacking can do for you.

 

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Financial Literacy

Let’s Talk Investment

Investing in scalable passive income strategies is the best way to make more money and increase your net worth. Sure, money won’t buy you happiness but it will buy you freedom. Freedom to focus on experiences and projects that truly matter to you.

Step by step we’ll explain how to take control of your finances, detail several asset classes to help grow a portfolio.

Welcome to this journey with us.