Debt is such an easy thing to take on but paying it off can be infinitely harder. Many of our members initially come to Grandma’s Jars carrying lifestyle debt that they have been struggling to get on top of for years. When approached in the wrong way, debt elimination can become frustrating and soul destroying.
In this blog post, I would like to discuss the 5 most common mistakes that most people make when trying to pay off debt.
1. Paying Off Debt Before Having a Budget in Place
Unless you have a plan for dealing with your future expenses, you can be certain that any ‘spare money’ you use to pay off your debt today will be needed tomorrow for an ‘unexpected’ expense. Without a budget you cannot possibly know what is truly ‘spare’ and therefore available for debt elimination.
We so often see people who, with the best intentions throw any spare money they have at paying off their credit card debt and then find they have insufficient funds to pay their bills. Needless to say, their credit card becomes their only option for paying their bills, and so the cycle continues.
The only sustainable way to pay down debt is to have a budget that helps you identify how much you need to set aside for future expenses and how much is truly available to pay off debt.
2. Paying Off Debt Without First Establishing a Cash Reserve
This is very similar to our first mistake- paying off debt without first having a budget in place.
Too often we see people who are throwing surplus funds at paying off their personal debt only to find that an unexpected expense or emergency comes up and they don’t have the funds available to cover, so once again the credit card or overdraft facility gets another work out. This is Murphy’s law in action and it can be very demoralising.
In our Road Map to Financial Peace program, we always recommend that before clients try to tackle their lifestyle debt, they should first have a budget and then use surplus funds to build a cash reserve of at least $2,000. This will ensure that any funds they use to pay off their lifestyle debt stays off their lifestyle debt. You will also be surprised how once you have your cash reserve in place, Murphy will choose to leave you alone.
3. The Scatter Gun Repayment Plan
Having multiple debts can be very hard to deal with. Without a purposeful repayment plan, people will just try to pay bits of money off of all their loans, dealing with whichever loan is most immediate at the time. This is a very reactive and unfruitful way to get ahead.
As outlined in our The Power of The Debt Snowball strategy, the most effective way to deal with multiple debts is to pay the minimum on all you loans except the smallest and then throw all your surplus funds at eliminating that first debt. This strategy achieves two things.
Firstly, you will see progress much faster as the balance of that one loan is reduced and secondly, you will be eliminating the number of debts you have to deal with which makes the overall task appear that much more achievable.
4. Consolidating Multiple Debts Into One Without Addressing the Issues that Caused the Debt
While consolidating lots of smaller loans into one debt can make sense, especially if that new loan is at a lower interest rate, it is important that you first identify and deal with the issues that caused you to be in debt in the first place.
Too often we see people consolidate all their bad debt into their home loan only to find that 6 months later their same bad habits have once again resulted in them accumulating more credit card and lifestyle debt.
Consolidating your high interest lifestyle debt into your home loan can be a very effective strategy but you should only do it once you have budget in place and are committed to living within your means.
5. Put All Your Expenses Onto Your Credit Card and Paying Your Income Into Your Home Loan
This is has been a favourite strategy recommended by the banks for over a decade.
Pay all your income directly into your home loan and then put all your expenses onto your credit card. While your pay sits on your home loan, you are reducing your interest payment on your home loan and as long as you pay your credit card off before its interest is due you will pay your home loan off years earlier.
While this works mathematically, the banks knows that people tend to spend more when they use credit cards than when they use cash. They also know that the interest they earn on their credit card it far greater than that on a home loan. Only a small percentage of the population can make this work, and by small I mean less than 5%.
The other 95% tend to spend more on their credit card than anticipated and the money they thought they saved on their home loan is gobbled up by a bigger than expected credit card payment.
This strategy does not work unless you have a very well established budget. The banks recommend it because the bank knows it keeps people in home loans longer and they know they can get away with recommending it because ‘mathematically’ it does work.