Financial Freedom Series
How to Achieve Financial Freedom – Part 3
Here we are at Week 3 to Financial Freedom. Over the last couple weeks we have looked at how to spend on purpose by looking at your spending habits in Part 1, and last week we discussed paying yourself first and saving money in Part 2. At this point, you should be in a good position with understanding your financial situation and have started to save money and set up some automatic transfers in order to make your saving decisions minimal.
This week we will be discussing how to put more money in your pocket by first understanding debt, and then we will dig into how to reduce or eliminating debt.
Regardless of what anyone tells you, remember that there is good debt and there is bad debt.
Good debt is when you have debt for appreciating assets or investments.
A mortgage would be an example of, or considered good debt, provided you have some equity in the property that is mortgaged. This is an asset that will appreciate over time and also provide you shelter and enjoyment in the long run.
Bad debt is when you have debt for regular purchases or depreciating assets.
There are exceptions – but consumer debt or credit card debt would normally be considered bad debt. Any debt you take on to pay regular budget expenses is bad debt as well.
When you’re making regular purchases: A good rule of thumb is, if you have to finance it, you can’t afford it. With obvious exceptions being homes and sometimes vehicles. If you think about your purchases and you can’t pay for it on the spot, then you should wait until you have saved the money in order to purchase it. I’m not dictating you shouldn’t use your credit card, but you should have the money in the bank to pay for the purchase.
- You want a new sofa, but don’t have the cash to pay for it? You can’t afford it.
- You want a new sofa, but have the cash in the bank to pay for it, you can afford it and go ahead and put that on your credit card!
I am a strong advocate of using credit cards, however, never carry a balance on them. I know many of you likely have credit card debt, and we will tackle eliminating that debt next week. However, if you have balances on your credit cards you are paying enormous amounts of money EACH month on interest on these balances, and then interest on that interest, and this compounds month over month.
With most personal loans, your loan payments are calculated using compounding interest, which is the interest that is added to the principal of the loan each month that the balance is outstanding, causing you to pay interest on interest. Although it’s designed to work against you, it’s possible to pay off the loan two to four times faster with minimal additional cost to you, just by knowing your magic number. Your magic number is the portion of your monthly payment that goes to pay just the principal. To pay your loan off quickly, double, triple or quadruple your principal, or “magic number” each month.
A great quote I love is one of Albert Einstein’s about compound interest. He said that “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” You want to understand compound interest and earn it – don’t be in the masses who pays it month after month.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Albert Einstein
Compounding is definitely a wonder and compound interest on debt will keep you in debt always. One month of interest on your debt may not seem like much to you in the present, but compounded over time and over an extended period of time will cripple anyone’s attempts at financial freedom. Once you get a handle on understanding this one key fact, you will be well on your way to earning compound interest, rather than paying it.
Here are a few tips to look into to understand your debt at this time:
- Look at your credit card statements. What is the balance you’re carrying for each? What is the interest rate for each of them? All credit cards are different and many have different interest rates or incentives attached to them. Understand what interest rate is charged on each of them, so that you know how to work on paying them off (to be discussed next week).
- Don’t keep any credit cards with annual premiums. Using a credit card, should be a convenience for you, but you shouldn’t have to pay a fee in order to use it. Most of the incentives offered on some of these cards with high annual premiums aren’t usually any use to you either if you really look at it. If you pay an annual fee for your credit card, cancel it. Or plan to cancel it once it is paid off.
- Have lots of credit cards, but only those that offer you incentives. As mentioned earlier, if you don’t have the money to purchase something on the spot you shouldn’t be buying it anyway. The only reason you should use your credit card is for convenience. And while you’re using it, why not use the card that gives you a cash rebate or travel points, or air miles?? These are incentives that you get for purchasing the items you need now. That’s why I mentioned earlier use your credit cards, but just don’t carry a balance on them. None of these incentives are any good if you’re paying for them through annual fees or monthly interest!
- Know your magic number on your credit card balances, your mortgage, your car payments, etc. All credit card balances can be paid in full, and most loan payments can be accelerated with additional payments to principal. These things help you to pay less interest, and get debt free. And when you’re not paying unnecessary interest to a creditor, bank or financial institution you will have extra money to pay yourself!!
Understanding debt and primarily compound interest is the second step in getting a handle on your financial situation. Determine whether you are paying compound interest or earning it. If you’re paying it, work on putting these tips in place for yourself, and understanding your debt situation, and we’ll see you next week to discuss Part 4 in your journey to Financial Freedom.