How to become Rich: Debt Ridden

Growing wealth out of a debt ridden starting point

If this is the first article that you're reading in the How to become Rich series then I encourage you to go back and read The Basics first.

The Debt Situation

You have dreams of becoming a multimillionaire. Unfortunately, for whatever reason, you have found yourself mired in debt. Perhaps it was due to a payday or personal loan. Perhaps you spent money that you didn't have and built up credit card debt or went into your overdraft. Or perhaps you too a student loan to go to University and earn a degree. Or perhaps you simply have mortgage debt in a property that you (part) own.

This short article aims to outline some basic strategies for planning to build wealth where the starting point is someone who is in debt.

Don't Save! Pay it off!

Shock! Horror! You read that correctly. I'm advising you NOT to save. If you have any debt I actively discourage you from saving anything. More than that, if you have some savings, use it to pay down any debt, making sure you have a few grand kept in reserve for emergencies (e.g. You lose your job).

Debt, savings and Interest

The logic for advocating using savings to reduce debt is fairly straightforward. Let us say that you have £5,000 of credit card debt that charges you 10% APR (highly unrealistic!in interest. You also have £10,000 in a savings account earning a fantastic 5% per annum. You are currently trying to build up a deposit on a house. Each month you pay the minimum required on your credit card but  manage to add £100 to your savings. This is a highly inefficient use of £100.

Let's consider what we are doing when we put away £100. Try to think of the £100, not as money but as a unit of assets. We are giving the bank 100 units of assets and they pay you (5%) £5 for the privilege (in interest). But you could have paid off £100 of credit card debt. Think of it as reducing your liabilities (that are harmful to your wealth) by 100 units. This would have saved you (10%) £10 in interest over the year. Now if I was to ask you would you rather have your income increase by £5 this year or for things to be cheaper by £10? Not sure? Let's increase the numbers: would you rather have £5,000 or would you rather have your next £10,000 worth of spending to be free? Obviously, the later is better! The same is true when the numbers are smaller.

It is better to pay off the credit card debt than to build up your savings so long as the interest on your debt is higher than the return you get on your savings (which it nearly always is). More than that, you should use any savings that you can spare (after you have built an emergency fund of about 3 months wages) in order to pay down debt. It is much better for cash flow and long term wealth building.

Debt and no savings!

Let's say that you have no savings but have got plenty of debt. Here are a couple of rules to live by:

1. Don't save! Pay off the debt as quickly as possible
2. Analyse what you can cut down on in terms of your monthly spending to free up more cash flow to pay off our debt quicker
3. If you owe money to several different creditors pay off the debt with the largest interest first regardless of the size of the actual debt
4. Sell things you don't need to pay off more debt
5. Consolidate your debt if possible to pay an overall lower rate
6. Remember that for every second you waste not paying of your debt, money is leaking from your pockets into somebody else's
7. If you are in real financial difficulties seek out the Government's debt advice scheme or the Civil Advice Bureau.
8. Know that you cannot even consider building your wealth until you eliminate all your "bad" debt. Bad debt reduces your monthly cash flow. Good debt increases your monthly cash flow. I will post a future article making the distinction clearer.

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Wealth Tortoise said...

Some great tips for giving your debts a good smackdown! Personally I found starting to save (just a little) while clearing debts worked very well for me. Even though in pure numbers terms it's not as efficient to do both at the same time, by having a little savings pot that you can build on from the start can motivate you a lot more each month to keep going than say reducing from £20,000 in debt one month to £19,900 the next - that's going to be a LONG road to travel! The battle is just as much mental as financial. It helps to feel you've got a bit of wealth to keep for yourself right from the start - along the same vein as 'pay yourself first' where your debt repayments are treated like any other bill.

Mr. Moneybanks said...

Hi Wealth Tortoise. Firstly thanks for commenting. I think you've got a really good point - you've got to be mentally strong to tackle debt. Personally, I believe it's better to rip the plaster off in one go rather than slowly. However, that is a personal preference and I understand why others may want to save a little whilst paying down debts. Keep in touch!

Mr. Moneybanks said...

See response below!