Bad debt generally refers to consumer debt, whereas good debt is usually debt that refers to assets or investments such as a mortgage. Bad debt can harm your efforts to get ahead financially so how do you get out of bad debt and get ahead? Read on..
First up, my take is that not all debt is the same. I want to make a delineation between ‘Good’ debt and ‘Bad’ Debt1 – although many leading finance experts dislike this grossly simplified analogy. Generally speaking, ‘Good’ debt is debt that is used to buy productive assets or investments that can more than service the loan charges (think: mortgages on investment properties, business loans and even a home loan for a PPOR in some situations).
‘Bad’ Debts come from things like Credit Cards, Personal Loans, Lay-Buys, Payday loans and financing cars, boats or other ‘toys’. Bad debt relates to consumer spending, living above your means and wasteful excess.
When you first think of ‘Bad’ debt in terms of financial independence, you might think that your first priority would be getting out of this toxic wealth trap as soon as humanly possible. However, this is not the case. Whilst I admire the fervent desire to become (bad) debt free, there are higher priorities that need to be addressed first. Actually, rushing to pay off your debt first could lead you right back into the very same debt trap you started in!
Once you are ready to pay the debt off though, you have three main choices: The Debt snowball (or domino), The Debt avalanche, or the Debt consolidation.
So, where does paying off your Debt fit into the steps of Financial Independence, and what is the best way to get out of debt? Let’s get into it.
Getting out of debt
Debt is a very corrosive thing. In addition to locking you into making repayments, additional interest accruing, as well as various unfair fees and charges, debt can seriously hamper your lifestyle and cause a significant strain on your personal relationships and family life.
“Significant debt was found to be having a negative impact on marriages, regardless of household income. Forty-one percent (41%) of couples who had consumer debt report they argue about money more than any other issue “(Cruze, 2018).Relationships Australia – Finances and Relationships3
The sad facts are that poor financial education, money and more specifically stress due to debt is the leading cause of relationship breakdown and divorce, as well as a massive causal factor into domestic violence and abuse.
Bad debt also prevents you from ‘getting ahead’ and building wealth. How can you possibly expect to grow wealth at the slow and steady, sustainable long term average of 10% per annum in the stock market or investing in real estate, when you are being charged 15-20% on outstanding credit card balances, or up to 50% on payday loans?
The simple answer is you can’t – you absolutely must pay off all toxic debts before you can get serious investing (but of course, this shouldn’t stop you from dipping a *small* toe in the market to learn more about investing).
The cruel reality is that it takes so much longer to pay down a credit card or other personal debt than it does to build up that same amount in an investment account – because of the powerful influence of compound interest.4
This is because every day you are paying down the debt, compound interest is being recalculated and the interest is getting added onto the balance – so it is working against you. However when you are investing, compound interest is working in the same direction as you, to grow your wealth. The only way you can beat the compound interest of consumer debt, is if you can find an investment that can out pace it AFTER tax. Spoiler alert – it is not possible. Investment loans only work when they are very reasonable interest rates, so trying to ‘outperform’ 10%+ on a bad debt just ain’t gonna happen.
However, rushing in and allocating all of your ‘money capital’ into paying down debt can be a trap too, especially if this leaves you without capacity to support yourself or your family, or without an emergency fund5. Why is an emergency fund important? Because no one plans to get into debt! This usually happens as a last resort when all other options have been explored. So rushing to pay off all of your debt without leaving yourself a breathing space can actually cause you to get into more debt later!
Avoiding getting into more debt
The key to getting out of debt is to avoid getting into more debt. This means being smart about how you pay off your debt. The BEST way to avoid this is to follow my ‘Ten Step Plan to Financial Independence’, because this strategy gears you up to fight your debt battle at the appropriate time.
Basically, If you ‘burn your powder’ on extinguishing debt too soon, it could leave you in strife down the track – if you blow your emergency fund to pay off debt, and then you have an emergency, what are you going to do?
Likewise, what is the point in trying to pay down debt if you don’t even have a budget? If you still have a $100 a month gym membership you don’t use, $40 a month in streaming services and a $150 per month phone plan (when you could have a $16/mo one like me) then what do you think these unecessary costs do to your ability to pay down the debt? What about struggling to pay down debt whilst you earn $20 an hour in the hospitality industry, when you could be making $40 an hour online as a Virtual Assistant and doing far more shifts from the comfort of your home?
There is an optimal way to do this. To recap, the Steps to Financial Independence are;
- Spark your FIRE
- Make a budget and track your expenses.
- Create a buffer – build an emergency fund of at least $2000 (to start)
- Cover your Ass – This includes Income Protection Insurance, Total or Permanent Impairment, Life (death) insurance, Health insurance, Professional indemnity / Liability insurance, Home and contents insurance, Auto insurance.
- Dip a toe – Become a (small) investor with microinvesting
- Reduce your expenses – slash your bills
- Boost your income – negotiate a raise and start side hustles
- Pay off bad debt
- Boost your Buffer – Build your emergency fund to 3-6 months living costs.
- Get serious about Investing
- Further your Education
Which puts paying off debt at number 8 in the list. This is because steps 1-6 can be achieved relatively fast, and will actually greatly benefit your ability to pay off the debt. To be honest, Steps 1-7 can be worked through (or started) in a matter of weeks, depending on how much effort you put into it. Which means the bulk of the time will be spent in steps 8,9, 10 and then forever in 11 as we somewhat ‘restart the cycle’ and do a financial health check each year.
So when it comes time to actually start paying off debt, there are three main methods. These are…
The Debt Snowball (domino) is best suited for: People who need a motivation boost and positive reinforcement.
The Debt Snowball or domino effect is the most popular method to pay off debt, popularised by the likes of The Barefoot Investor and Dave Ramsay. The key benefit from the debt snowball is the psychological benefit of knocking down your debts, one at a time, and building momentum.
The Barefoot refers to it as ‘Domino your Debts’, which means knocking over the smallest first (regardless of interest rate). Whilst this isn’t strictly speaking the most *mathematically* optimal way to clear your debts (and this is just the inner engineer in me coming out), the Debt snowball makes use of a powerful psychological motivating factor of eliminating payment transactions from your account – one at a time.
Put simply, it is easier to pay off the smaller, annoying balances, than it is to pay off the big ones. So the debt snowball lets you start small, and snowball your way into paying off the bigger ones. The positive reinforcement you get from paying off these debts will help motivate you to keep paying them off, and it will be a weight off your mind seeing them gone.
For example: you have a personal loan for $10K at 7%, student loans for 40K at 2%, a credit card for $4K at 20% and a parking ticket for $500 at 5%. The debt snowball says to prioritise paying this off in the order:
- Parking ticket ($500)
- Credit card ($4000)
- Personal loan ($10,000)
- Student loans ($40,000)*
*Personally, I would never pay down student loans if the interest rate was 2%. I would instead pay the minimum and be investing the difference to reap the benefit of 10% average market returns.
The Debt Avalanche is best suited for: Disciplined people who are good with numbers.
The Debt avalanche is the more mathematical or ‘numbers based’ approach to paying off debt. Put simply, the debt avalanche concentrates on the highest interest repayments first. This means in the long run, you will save the most in interest repayments. This only works if you are very disciplined and are generally good with numbers and don’t need the psychological ‘helping hand’ of the debt snowball.
For example: you have a personal loan for $10K at 7%, student loans for 40K at 2%, a credit card for $4K at 20% and a parking ticket for $500 at 5%. The debt avalanche says to prioritise paying this off in the order:
- Credit Card (20%)
- Personal loan (7%)
- Parking ticket (5%)
- Student loans (2%)*
*Again Personally, I would never pay down student loans if the interest rate was 2%. I would instead pay the minimum and be investing the difference to reap the benefit of 10% average market returns.
The Debt consolidation is best suited for: When you are completely overwhelmed and considering bankruptcy
The Debt consolidation7 needs to be done in conjunction with a financial advisor or debt consolidation specialist. A trained professional (Make sure to check their credentials on the ASIC database) can actually act as your representative and sort all of this out for you, consolidating the debt into one ‘easy’ regular payment. They will act on your behalf and deal with creditors and any debt collection agencies, which can take a lot of the stress away from you and stop them from chasing and hassling you directly.
This is often a much better course of action than declaring bankruptcy8, since bankruptcy can have significant implications on your life – such as failing security checks, not being able to get finance and credit, and even being barred from being the director of a company or starting your own business.
For example: you have a personal loan for $10K at 7%, student loans for $40K at 2%, a credit card for $4K at 20% and a parking ticket for $500 at 5%. The debt consolidation says to prioritise paying this off in the order:
Dont worry!! – just make your debt consolidation repayment: The consolidator sorts out the details!
Just be aware that a debt consolidation method is not the cheapest way to pay this debt off, of course the debt consolidator will be charging you for this privilege of simplification – which in itself can be a dangerous trap when it comes to debt, as it is really about accepting responsibility and putting in the hard yards to clear it out. However, if you are totally overwhelmed and can’t think of any other option, it is here.
If you are at this stage and feeling overwhelmed, you could try to organise speaking to a financial counselor for some obligation-free advice. They may be able to provide some unique insights for your personal situation to help get on top of mounting debts, and start pointing you in the right direction.
Bad Debt in Accounting
Bad debt has a slightly different meaning when we talk about small business and accounting. Since I am now running a small online business, I wanted to include this definition as if you do the same, you may find yourself in a similar position to me with some bad debts that I have to write off (that is, bad debt from clients who refuse to pay their invoices for work I have done for them – which does suck!).
The definition of bad debt in accounting terms is when customers have a receivable that they cannot or have not paid. According to accountingtools.com9, “Bad debts are possible whenever credit is extended to customers. They arise when a company extends too much credit to a customer that is incapable of paying back the debt, resulting in either a delayed, reduced, or missing payment”.
When accounting for bad debt and bad debt expenses, MYOB10 states that it depends on whether you’re using a cash basis or accrual basis for recording income and for outstanding accounts receivable. For a cash basis (recognising income only when cash is received), no adjustment would be necessary as the income would not have been recorded in the reporting period. For the accrual basis (recognising income when it is invoiced), the bad debt would need to be on record. The bad debt would need to be taken out of the debtors (or accounts receivable) and recognised as a ‘bad debt’ expense in the profit and loss statement of the business.
As MYOB states10, “a debt does not need to be a write-off in the year in which it first becomes bad; however, for income tax purposes and for the business to claim a tax deduction, the debt must be written off as bad in the income year it is being claimed.”
Financial debt can be soul crushing and is the leading cause of relationship stress and breakdown. Not all debt is the same, and sometimes paying off your debt is not the smartest first priority. Whilst I admire the fervent desire to become (bad) debt free, rushing to pay off your debt could lead you right back into the very same debt trap you started in!
It is more important to follow the steps to Financial Independence, which prioritises establishing an emergency fund, creating a budget, slashing your bills and boosting your income first.
Once you are ready to pay the debt off though, you have three main choices: The Debt snowball (or debt domino), The Debt avalanche, or the Debt consolidation. Your choice will depend on your personality and types of debt. The most popular is the debt snowball, where you tackle your smallest debts first. The most analytical is the debt avalanche, where you tackle your highest interest repayments first. Finally, if you are completely overwhelmed, you might need to consider the debt consolidation – where a trained financial counsellor or specialist will manage your debt repayments for you.
Once you are (bad) debt free, it is time to move onto step 8 – Boosting your emergency fund!
- ‘Good Debt vs. Bad Debt’, Bill Fay, Debt.org. Accessed online at https://www.debt.org/advice/good-vs-bad/ on 13 Sep 2022.
- ‘Financial Statistics’, Money Habitudes. Accessed online at https://www.moneyhabitudes.com/financial-statistics/ on 13 Sep 2022.
- ‘January 2019: Finances and Relationships’, Relationships Australia. Published: Feb 18, 2019. Accessed online at https://relationships.org.au/document/january-2019-finances-and-relationships/ on Sep 13, 2022.
- ‘Compound Interest: Explained With Calculations and Examples’, Jason Fernando, Investopedia. Published: July 19, 2022. Accessed online at https://www.investopedia.com/terms/c/compoundinterest.asp on Sep 13, 2022.
- ‘Why you should set up an emergency savings fund’, Rachel Horan, Savings.com.au. Published: May 19, 2022. Accessed online at https://www.savings.com.au/savings-accounts/emergency-fund on Sep 13, 2022.
- ‘How the Debt Snowball Method Works’, Ramsey Solutions. Published: July 14, 2022. Accessed online at https://www.ramseysolutions.com/debt/how-the-debt-snowball-method-works on Sep 13, 2022.
- ‘Debt consolidation and refinancing’, MoneySmart.gov.au. Accessed online at https://moneysmart.gov.au/managing-debt/debt-consolidation-and-refinancing on Sep 13, 2022.
- ‘What is bankruptcy?’, Australian Financial Security Authority (AFSA). Accessed online at https://www.afsa.gov.au/insolvency/cant-pay-my-debts/what-bankruptcy#:~:text=Bankruptcy%20is%20a%20legal%20process,and%20submit%20a%20Bankruptcy%20Form on Sep 13, 2022.
- ‘Bad Debt Definition’, Accounting Tools. Published: April 6, 2022. Accessed online at https://www.accountingtools.com/articles/what-is-a-bad-debt.html#:~:text=A%20bad%20debt%20is%20a,%2C%20reduced%2C%20or%20missing%20payment on Sep 13, 2022.
- ‘Bad debt explained: What is it and what can you do about it?’, Tracey Sharah, MYOB. Published: January 1, 2021. Accessed online at https://www.myob.com/au/blog/how-to-handle-bad-debt-accounting-explained/ on Sep 13, 2022.