﻿Paying off debt is a worthy endeavor, but there’s a right way to do it and a wrong way to do it.
There’s three big mistakes I see when people pay off their debt, there are others,
but there are three big ones. Number one is draining their emergency fund to pay off
debt. And here's how the story usually goes: The individual "sees the light" about their debt and
how much it's costing them in interest — which is phenomenal, by the way — and then, in a frenzy,
they put every penny they have toward paying off their debt, knowing that by doing so they're
saving a lot in interest. But here's the problem: Life happens. Their car breaks down and needs
a $750 repair. Their kid chips a tooth and they need to pay $1,200 to the dentist. They lose their
job and can't make their $2,000 rent this month. And here's the bigger problem: Because they've put
every penny they have toward their debt, they no longer have an emergency fund to tap into in
these "rainy day" situations. So what do they do to get through these tough times without an
emergency fund? That's right. They accumulate more debt. They put these expenses on their high-APR
credit card. They get an outrageous payday loan with sky-high rates. And they end up being in
a worse financial position than they started in. The better strategy here is to stash away at least
three to six months' worth of living expenses as an emergency fund and then put every penny you
can spare toward paying off your high-interest debt. I know it may be painful and feel
counterproductive to have money sitting in the bank that could be used to pay off your debt
that's accruing interest at high rates, but just view your emergency fund as an "insurance policy"
against the unexpected circumstances that life throws at us. Number two mistake I see people
making when paying off debt is paying off low-interest debt before high-interest debt.
Maybe they heard about the "debt snowball" — this approach to paying off debt says that one should
pay off their debts in the order of the smallest debt to the largest debt, regardless of interest
rate. The thinking here is that as each debt is paid off, the individual gets a psychological bump
that encourages them to keep going. I would say it is, perhaps worth it to approach debt payoff this
way to an extent. If someone has three debts — one for ten thousand dollars at a 9% interest rate,
one for three thousand dollars at a 8.5% interest rate, and one for one thousand dollars
at a 8% interest rate — I really wouldn't have any problem with them tackling the one-thousand-dollar
debt first to get pumped, even though it has the lowest interest rate of the three debts. But if
that ten thousand dollar debt was a credit card with a 25% interest rate, you'd better believe
I'd say that this individual should pay off that debt first before worrying about the one thousand
dollar and three thousand dollar debts at a lower interest rate. In fact, by leaving the larger,
higher-interest-rate debt for last, the individual could end up with more accrued interest in total
on all their debt by the time they pay off the smaller debts. Don't blindly follow the "debt
snowball" or "debt avalanche" approach. No one knows your debts and no one knows your personal
capacity for self-motivation more than you do. Simply use common sense and math. If you think
that using the debt snowball approach will really motivate you to pay off your debt, that's fine,
but make sure you've done the math — or worked with somebody who can run the math — to evaluate
what using that approach may cost you in terms of real dollars of interest accrual. Mistake
number three I see when people are paying off their debt is not looking at all their options,
especially options that will either get rid of their debt entirely or at least allow them to pay
it back at a lower interest rate. I see this a lot as a CPA with people who owe a lot of money to the
IRS. Plenty of people think they need to dutifully pay their back taxes to the IRS, when the reality
is that the IRS has programs such as the offer in compromise that can essentially wipe away some or
all of their tax debt, I have a couple videos on my channel about the offer in compromise that I
would urge those of you who owe back taxes to watch. The same is true for other debt as well,
such as federal student loans that may qualify for some kind of forgiveness in the future. Another
option is refinancing one's debt with a lower interest rate. Although this takes time, it could
really pay off in terms of interest savings. I personally refinanced my student loans from
something like an 8% interest rate, I think, to a 2% interest rate after I graduated from college.
This literally saved me thousands of dollars over the life of my loans! Ignoring options like these
could literally cost you thousands if not tens of thousands of dollars when it comes to your debt.
So educate yourself and know your options when it comes to dealing with your debt. Yes, paying off
your balances in full is the typical way to manage debt, but depending on your type of debt and
situation, there may be better options available that can jump start your debt-free journey. Hey,
if you appreciate my approach to personal finance, I actually put together a course recently called
Prosper, and in this course I basically share all my thoughts on personal finance, from budgeting to
saving to retirement to taxes, and I have a coupon code for my YouTube audience in the description
below, if you’d like to check out this course, there’s more information in the description below,
if you’d like to hear my own story of paying off debt, check out this video right over here
and if you’d like to see an embarrassingly poorly-produced video I made when I was just
starting my channel about how to deal with your holiday debt, check out this video
right over here, and yes, I do wear a Santa hat in it. See you over there, folks, buh-bye.