The popular teaching today is “debt is bad, pay off all your debt including your mortgage, any type of debt is bad.” Not only is that wrong, but it’s directly the opposite of how millionaires often create their wealth.
You may remember hearing the phrase “Other Peoples’ Money” or OPM? An important wealth building principle is to use OPM to borrow from (banks, credit card companies, individuals) and create wealth. Why? Because the way you build wealth is to compound at high rates of return and debt increases your rate of return.
Let me give you an example. Let’s say you buy a home for $100,000 cash (no debt) and it increases in value in a year by $10,000. You’ve gained $10,000 on a $100,000 investment for a 10% annual return. Compare that to your friend who also bought a home for $100,000, but put 10% as a down payment and borrowed 90% with a mortgage. The house appreciates by $10,000 in a year. Since they only put down $10,000 and made a $10,000 gain, that’s a 100% return or 10 times your return! The significance of that is not only has your return increased by 10 times, but if you were able to start with only $10,000 to invest and you did that every year, in a little over 7 years you’d be a millionaire!
The power of compounding is enhanced by leverage and is powerful IF you use it for appreciating assets. That’s were most people get it wrong. They use debt for depreciating assets like clothes, cars, trips, RV’s, and other grown up toys that lose value over time.
Here’s my point: it’s really buying the depreciating assets, not the debt, where you are going wrong. Debt is a powerful tool for wealth building if used correctly. If used incorrectly (buying “stuff”) it will hurt you. It’s time to stop making debt the villain. It’s a wealth building tool and is not bad in and of itself. Let me ask you this: why is credit good, but debt is bad? In other words, it’s great to have good credit, but the moment you use the credit it’s bad? It’s not about the debt or credit, it’s how you USE IT!
To be a good wealth builder, you need to know how to use it skillfully. That’s what most millionaires do. They understand debt and credit to the nth degree. Now that you know debt is good when used to increase the rate of return on an appreciating asset, let’s talk about how to get you out of credit card debt.
What you’ve been taught about how to pay off credit cards is also incorrect. You don’t want to pay off your smallest balances first. That is not only the most costly method, it will also hurt your credit score. Why? Keeping the largest balances of debt the longest is the worst possible thing you can do to your credit. How would you like to improve your credit score while paying off your consumer debt? Let me show you the steps:
- Create 6 columns on a piece of paper (horizontally works best): Column #1: Credit Card Name, #2: Balance, #3: Maximum Credit Limit, #4: Ratio of Debt to Credit, #5: Interest Rate, #6: Minimum Payment. Fill in the rows and columns with your debt information.
- For column #4, it’s an easy calculation. Take your debt balance (column #2) divided by maximum credit limit (column #3). For example, let’s say you have debt on two credit cards, card A and card B. If you owe $4,000 on card A and it has a credit limit of $10,000 (that’s 4,000/10,000 = .4) and on card B you owe $4,000 and it has a credit limit of $5,000 (that’s 4000/5000=.8).
- Rank the cards with the largest ratios first. In our example, you would rank card B (.8) above card A (.4).
- Pay more on the card with the largest debt ratio (B=.8) and the minimum on the lower debt ratio card (A=.4). When you lower your credit card ratio to .5 or lower, your credit score will improve. That’s just part of the algorhythm that credit card companies use.
- Continue doing this until your debt ratio gets to .5 on your cards. It will take time to complete this, but when you have, go to the last step.
- Go to column #5 and rank by highest interest rate. Pay more on the card with the highest interest rate, and the minimum on the rest, thereby saving yourself money by paying off higher interest rates.
Is this worth it? Yes! By paying according to the debt ratio, you will be improving your credit score as you pay off your debt which will allow you to buy a home, refinance, or buy an appreciating investment sooner so you can get your wealth building back on track!