In our latest blog post we have shown you why you cannot trust banks, why the laws are never in your favor if you are in debt, and how you can generally improve your finances.
In this post we will go a step further.
Avoiding debt is one thing, but what can you do if you already are in debt?
And more importantly: what is the best way to get out of debt?
The fastest way out of debt
If you are reading this, I assume that you probably have needed some quick cash sooner or later in life or have just fallen for some trickster or scheme that ultimately put you in debt.
At this point you have to get out of this situation as quickly as possible.
If there are many sources of debt and you don’t know where to start, begin by what is called the debt snowball method.
Here is the fastest way to do it:
1. Make a list of all your debts. At this point do not yet look at interest rates, fees or anything else. Just get clarity on how many institutions you owe money to, and how much you owe to each one.
2. Negotiate with our creditors to only make the minimum payments for a certain time on all existing debt.
3. Look for the smallest debt you have - and pay it off with all the excess cash you have left. Use all the financial power you have, scratch together every penny you can. Do whatever it takes to bring in some extra money. We have to reduce the number of debtors to reduce the number of fees and interest - more on this later in the article.
4. As soon as your smallest debt is paid off, you now take that extra cash and pay off the next biggest debt you have.
5. Repeat this method until you are debt-free.
This method is the quickest way to reduce debt and make your finances less vulnerable to fees and interest demands from all angles.
The sooner you can reduce the number of debtors, the quicker you can pay back the remaining debtors one by one. By focusing all your financial effort on one debt in particular you can begin to eliminate them one after the other.
An example of the debt snowball
First of all, make a list with all the debts you have with the interest payments you have to make.
An example could could look like this:
Credit card 1: 7.650$ at 4% interest
Credit Card 2: 800$ at 5% interest
Car loan: 20.000$ at 4,25% interest
Student loan: 30.000$ at 2,8% interest
Total: 58.450$ in debt
Let's say you can pay back only around 500$ per month with your current salary and that is really the best you can do.
Where and how should you start?
There are some basics about financial institutions that you have to understand:
Every single form of debt will have fees and interest rates on it.
That means, the first and most important step you should take is to minimize the number of creditors you owe money too.
Every one of your debtors will charge fees and interest.
In many cases the debt itself is not the biggest problem, it is the often ridiculously high fees for “servicing”, account maintenance or similar.
Such expenses often hit you unexpectedly, just when you thought you paid off some of your debt you actually just paid some more fees - while your debt level stayed the same!
The more creditors you owe money too, the less it is even possible to calculate the risk you are in.
In our example you have 4 institutions you owe money to - now make them 3.
The fewer of them, the better.
But where should you start?
You should start with Credit Card 2.
Why?
With only 800$ it is just a waste of money to allow the credit card company to charge any form of interest and fees on you for such a small sum.
Therefore with your available 500$ a month you fully pay back the Credit Card 2 as soon as you can.
Voila! - In 2 months you have reduced the first creditor.
For all the other payments, make an agreement to pay back only the interest or minimum payment for a certain period of time.
Often banks accept such a delay of payments for a few months or even a year, but you will usually have to pay back at least the interest on a monthly basis.
But within 2 months you would have eliminated a whole debtor out of your list.
Now you will have more money freed up to pay back the remaining debts.
Again I would recommend to start with the smallest one from that point, and put all others on delay for as long as possible.
From that position you can work your way forward and tackle one source of debt after the other.
This will reduce your exposure to as few banks as possible and unite your monetary efforts all in one direction, in our example credit card 1 would be the next best option.
By taking your debts one by one instead of facing all simultaneously, you will be far better off to deal with one single financial institution than with multiple of them putting pressure on you from all sides.
With this strategy and discipline you will be good on your way to a better financial life.
Getting out of debt still does not mean you made it, but it is an essential part of your personal way to achieve financial success.
Should I pay back the mortgage for my house / apartment?
There is hardly any real estate in the world that is bought without the help of a bank.
Real estate is the most common cause why people take out a loan.
So what should you do if you are in 6-figure debt because you bought a property?
If the house or apartment you live in is the only form of debt you have - don’t panic.
The house itself has value.
When you take out a mortgage to buy a house, the bank does a solid check of the property and will try to find out the specific value they could sell it for.
As part of their due diligence, the bank will never give out a loan that exceeds the value of the property itself, and you will always be asked to make a down payment of 10% to 20%, or even more.
That means houses and apartments will usually keep or even increase their value, except for the financial crash we had in 2008 when the Real Estate Bubble was bursting.
Since this form of lending money is also a very safe bet for the financial institutions, banks charge smaller interest rates on mortgages backed by real estate than they would when you take out a loan to buy something that decreases in value, such as a car for example.
The property you buy with the loan itself acts as a security, which demands less additional costs from your side to be paid.
If we put this together, you pay a very small interest rate, and the house you live in acts as a counterweight to the debt you owe to the bank.
This makes debts on a real estate to live in far more common, and also far less threatening for your personal finances.
Overall with inflation real estate will even increase in value over the long-term, while the debt with its value in dollars will decrease over time.
In the worst case you can always sell the house, and pay back what you owe.
Thus if you have debt on the place you live in, usually this should not be that much of an issue.
However, you still should keep an eye on the monthly mortgage rates. Make sure you are in all circumstances able to pay these rates.
At the time of writing this, there are insane prices for housing around the world.
If you make 60k per year, it should be a no-brainer that the house for 800k is out of your reach.
Just look for objects that are appropriate in their price and value for your budget and be realistic with your demands.
But overall, the mortgage on a house is the last thing you need to pay off.
If you have excess money to spare, sure you can pay it back too.
But as part of the debt snowball, there is no necessity to get rid of the mortgage on your property.
Why debt will have a negative impact on your life
In times when some people even finance their furniture, one could ask what the problem is with having debt.
First of all, debt limits your ability to save money.
In our post on What Is Money we explained that for having the financial system work in your favor you will need to receive interest.
But as long as you are in debt you do the opposite - you pay interest.
The next critical thing is that for any future investment that you want to make, such as buying a house, investing in a business, etc. your debt-to-income ratio (DTI) will be closely observed.
Having lots of debt means your future ability to take on larger financial steps in any form will be severely limited.
Of course this will also make it harder to save for retirement, send your kids to college, or any other large financial movement you will plan to make during the next decades.
A huge problem will also come your way when you should fail to make payments on the debt sooner or later
If you are short on cash you do not purposefully do anything bad.
You also don’t want to harm anyone, but sometimes there will just be less money in your pockets.
We have all been there.
Only a month or two of this kind are enough that even after years of payment and good relationships, the bank can come to haunt you and become an unfair enemy.
The problem is that legally, you will be considered to have “harmed” the bank financially by not paying your rates and therefore they are allowed to put severe pressure on you.
Compounding Interest on Debt
If you have debt from several sources, you first have to face the harsh reality and accept that you will have a tough road ahead of you.
And to really see what too much debt can mean to a person, let’s look at a possible scenario:
In case you have already read the other blog posts we published about finances you will have come across the incredible power of interest and especially compounding interest.
If you actively invest your money and receive interest payments on an ongoing basis this can be the biggest financial advantage you will ever need.
Interest can literally create money out of thin air.
Over longer periods of time, this effect only grows larger and becomes more powerful.
While this is great news for investors - you probably also have noticed that there are always interest payments to be made on debts you owe.
Your debts will compound and the payments to keep debt only at the existing levels will rise exponentially.
If you are in debt, compounding interest is not working in your favor - it is working against you.
This means your debt wil automatically grow larger because of the interest charged on it.
From then on your debt increases all by itself, even if you never borrow money again.
Let's say you are in total 70.000$ in debt for unpaid credit card spending and a car payment. If you cannot pay the rates the first time, you will be additionally charged extra fees for missing the payment, and additional extra interest which you will have to pay.
The bank is legally allowed to charge you all this without a word of warning.
Since your rates were not paid on time, they can reconsider your risk as a borrower.
Thus the bank raises the risk level you have been in and now charges more than before to “cover the risk”.
This simply means it will get more expensive for you.
You could not pay because you had financial issues.
And now you have even more financial issues because your interest on your debt just increased.
It is a vicious circle.
The lesson here is simply:
Financial issues can multiply by themselves.
If you are on trouble for whatever reason, you will now face even more trouble.
If all your debts was previously issued with a 5% interest charge but you just lost your job, had a divorce, or some other stroke of fate hit you and you couldn't make payments for a month or two, it could already be enough to get you drastically off course.
Such worst-case scenarios should always be taken into account before taking on any debt.
Make sure you have enough capital to spare to make payments, come what may.
If the monthly payment was 600$ and you missed it last month, the bank can now make you pay for that same month that you missed just one payment 2.000$ altogether!
This can happen without any warning, and yes, they are legally allowed to do that (“Didn't you read the contract?”).
As a normal person you would assume you now have to pay 1.200$.
This would be double the amount because you have missed a monthly rate - and would thus be reasonable.
Sure you would expect the bank to charge an extra sum of maybe 50$ for the late arrival of the money you owed.
But no - they can more than triple the amount and make it in tough times even a lot tougher for you.
You better pay those 2.000$ now before they will charge you again with more extra interest on that and even hire a lawyer to suck the last piece of blood out of your veins!
The bank’s math in such cases is just insane:
600$ + 600$ = 2.000$
Talking about making easy money!
Beware of Banking Fees
Did you know that there are more than 17 different words in the financial jargon that all mean “fees” in the end?
Financial companies are very creative when it comes to charging people for all kinds of stuff, even if they have to make things up in their mind. These fees cannot be discussed and hardly ever negotiated.
In plain English, if you should ever pay a bank or other financial institution their monthly rates too late, or not at all for a certain time, they will charge you interest on the interest and fees on fees.
There are no real regulations by the law to how much they can charge - In my time as financial advisor I have seen extreme cases where amounts triple within a week without any warning whatsoever.
What's more is that if we go back to the example 70.000$ of debt for credit cards and a car loan, the initial interest rates can jump enormously once you could not make your payments a few times.
Suddenly when you previously paid 5% interest rate, then you will easily be forced to pay 17% because you are now considered a “higher risk” to the bank.
Especially car loan and credit card debts (Yes, those seemingly “small” forms of debt!) often have ridiculously high penalties for not paying the required amount or for paying late.
Let’s look at that example in closer numbers:
From annually 3.500$ interest payments, it would jump to 11.900$ per year only in interest!
That makes almost 1.000$ a month only in interest payments - without any amortization or fees taken into calculation!
Refinancing your debt
Another option you might want to take a look at is refinancing.
Basically every form of debt you have can be refinanced.
This means nothing else than you take the debt from one financial institution and pay it back with new debt from another financial institution.
Changing one bank for the other?
Why would anyone want to do that?
The exact terms, conditions and interest payments from one loan to the other can differ vastly.
Banks or other financial companies are constantly competing for market share.
From time to time, one of them will come up with really cheap financing offers.
Especially if you have debt from several sources with multiple numbers of fees and charges on it that might accumulate to insane heights, it can be a valid idea to pay off all existing debt with a new creditor.
Since you only owe money to one institution from then on, getting a clear overview of all your fees and extra charges is now much easier.
A common financial vehicle used for this is called a debt consolidation loan, which is especially made for such purposes.
This is a loan specifically designed to cover your existing debt and refinance them under one new contract.
The construction of all loans is thereby always the same:
There is an amount you owe which will be paid back in monthly rates
Calculated into these monthly rates will be interest payments and additional fees
Further charges or fees may apply, depending on the financial institution
As long as the new debt you take out offers better conditions than the old rates you had to pay, this will be a viable option to consider.
Especially if you owe money to several debtors and have lost oversight over multiple contracts and agreements.
Debt settlement companies
If there is no way out of your personal debt and you already consider personal bankruptcy - wait!
There is still one last resort you have.
It is to call all your creditors and speak openly that you simply cannot make the demanded payments (or payments at the demanded interest rate + fees), and explain that if there is no settlement agreement you would have to file for personal bankruptcy.
Why should the financial institution agree to this?
In case of personal bankruptcy, the creditors would be left empty handed in most cases, and they know this.
That means they would likely receive zero dollars from you, although your private financial life will also be severely limited from then on.
If you can make a genuine and realistic offer of what you could pay them, they might agree to settle for a smaller amount than the original sum demanded. It is fear of missing out on all of your outstanding payments working in your favor.
Usually this also means new negotiations of interest rates, which could further benefit your situation.
Many banks would rather take 15.000$ they can expect from you than demanding 35.000$ you could never pay them.
Often this can help you to settle for much less than you owe - simply through negotiating.
In some countries there are also specific companies that offer debt settlement services.
This means they contact your creditors and make the negotiations for you.
Beware however, that there will always be a fee charged for this.
After all, this is their business model.
There are also other risks involved when you choose to work with a debt settlement company.
Some of these companies might urge you to stop paying your current creditors immediately. Depending on how successful the negotiations will be, this tactic could quickly backfire at you.
If you simply don’t pay the monthly rate, the banks can charge extra fees and extra interest in ridiculous heights as we already mentioned in previous examples.
Remember: by not paying monthly rates for whatever reason, you will be considered to have “harmed” the bank and broken your agreement. Thus severe action might follow.
Therefore it is safer to just pay your monthly rates as long as you can, and afterwards negotiate a settlement.
Improve your finances and get out of debt
If you plan on living financially free one day, then make sure you are not in any kind of private debt.
Never owe large sums of money to someone and in particular not to a bank!
You will be fighting a battle that is designed against you and thus makes it almost impossible to win.
Banks are the core of the financial system, they control the system.
It will drain your financial resources and will also make saving for your future more difficult.
The best way to avoid ending up in a situation as described is to simply spend less than you earn.
I fully understand that this will require full discipline and determination on your side, because it will force you to make hard decisions for the next few years.
It will mean not to buy the new car you desire, even though your stupid neighbor drives around in his leased Porsche all day.
It might require you not to move into that beautifully new home in this great neighborhood in the best area of town, and to live in your old run-down apartment complex for a little longer even though you could afford the monthly mortgage payments.
It will mean general abstinence from many consumer behaviors, like not going on a shopping spree out of pure boredom, not buying that expensive dress or that designer shoes but choosing moderately priced goods.
Instead we will be saving and investing to be able to turn the game around and receive interest for yourself and your family in the long run instead of paying interest to a bank.
Saving and investing might not give you short dopamin kicks or boost your self-esteem. But it is the way to drastically improve your economic conditions over time.
The Point Of No Return
Unfortunately, there is not always a good ending in such stories.
The problem with the situation of most people is that there are not too many ways to boost the income, and if debts are already eating up large chunks of your income there will not be much left for you and your family.
To find ways for boosting our income, check out our blog posts on starting a business.
If the interest rates on your debts are skyrocketing high and start compounding, there will be a point of no return - from where it is impossible to break out of the circle of debt because the interest increases much stronger and faster than you would ever be able to increase your personal income.
I have seen families being ruined by trying to get rid of 150.000$ in debt. They were being charged with ridiculously high interest rates and of course lots of extra fees to make poor people even poorer.
After years of hard work together in their jobs and paying to the bank all they could, they still ended up with 140.000$ in debt 10 years later.
The reason is simple:
When your income is 40.000$ per year but your interest payments alone make up 35.000$ per year and all this is still compounding and getting worse every year plus you are charged fees additionally, then you have reached the point of no return.
Your debt is compounding so fast, that your current income wont be able to pay it off.
In cases like the mentioned family that I witnessed, it is sometimes better to just surrender if there is no way out and you know you will never be able to pay back the mountain of debts. Compounding interest can grow at an unbelievable fast pace.
In such extreme cases I am sorry to say it, but personal bankruptcy might be the last option before you try to fight a battle you can never win.
However, make sure you try all the other options we mentioned in this article first!
Depending on the country you live in, often you will be able to restart your financial life after around 10 years at zero.
Sure those 10 years might be hard, but it is better to suffer for 10 years and enjoy a dignified life later on than being enslaved for the rest of your life.
Whatever you do, never ever ever let your debts reach the point of no return.
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