6 || Debt Elimination

1. Which is more important to you:  building your wealth or paying off your debt? 
2. How do you currently control your finances and manage your debt?
3. What does net worth mean to you?

In the investment world, we are taught that to build our net worth, we must accumulate more and more assets. However, the equation for determining net worth is simply assets minus liabilities. Additionally, net worth equals ownership and ownership equals wealth. So in order to be wealthy, does that mean that we need to own more and more things? Perhaps not because people can have many possessions yet own none of them (their creditors do!). If you are not able to pay cash for everything, then liabilities will always accompany the accumulation of your possessions; therefore, another way to accumulate wealth is to eliminate liabilities. In other words, if you truly want to be wealthy, you have to eliminate debt!

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The course Financial Planning: Statement Analyses discussed debt and some of the problems associated with it, the major problem being INTEREST. Remember, interest is the cost you pay for using credit (which is usually used to accumulate more possessions). Therefore, a debt almost always carries with it interest, and paying interest is the greatest obstacle to accumulating wealth. Since the main objective of this program is to help you accumulate wealth, this course will focus on the elimination of debt.

There is a simple formula for wealth. The formula is an algebraic equation, which seems to have been forgotten in the investment world. The formula is as follows:

(Time x Capital) + Knowledge = Wealth (ownership)

At first glance, this formula may not make much sense, but the financial logic of this formula will become evident as we discuss its components: time, capital, and knowledge (we have already covered wealth).

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Time

Time is the one factor that no one has control over. Time can work either for you or against you. You can make time work for you if you make wise financial decisions. In other words, as time passes and if you are wise with your cash flow, your wealth should increase. The opposite also holds true: if you make poor financial decisions and accumulate your possessions by going into debt, it could take years to pay for everything, and your potential wealth is lost. In other words, by the time you pay off all of your debts, your time to accumulate wealth has passed you by.

Note: Potential wealth is the possibility of increases in net worth over time (factoring in savings in cash flow that is properly invested).

Capital

The next factor in the equation is capital. Another word for capital is money. When you multiply your money by time, your wealth grows, and your net worth increases; however, if you truly want to be wealthy, you will use your time and capital wisely. This brings us full circle to potential wealth. When capital accumulates over time, it often grows faster because of compound interest (interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan, or debt). Misused capital subsequently equates to lost potential wealth and loss of greater net worth!

Knowledge

The most important factor in this equation is knowledge. When it comes to managing your finances and creating wealth, knowledge really IS power. We are all knowledgeable in certain areas, but it is the accumulation and compilation of knowledge within a specific realm or subject that makes us an expert and thus gives us the ability to take action and accomplish certain tasks. In other words, the more knowledge you acquire about a particular subject, the more powerful you become in exercising that knowledge. For example, an auto mechanic who has studied auto mechanics through books and hands-on learning understands automobiles and how to repair them. His or her knowledge about automobiles enables him or her to repair automobiles and the power to profit from them. Likewise, the knowledge that you gain from this course will grant you the ability to handle your finances with expertise. You will have the power to make better and more prudent financial decisions that should help you to eliminate debt and accumulate wealth.

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How to manage one’s personal finances is often a mystery. Rarely anyone is taught how to build wealth. Unless we have a financial guru as a teacher, most of us are left to flounder with our finances and to learn financial management through the school of hard knocks—making wrong decisions as we go! In addition, we are often torn between multiple strategies on how to budget, invest, and manage debt; we are often brainwashed by the media on how to best manage our finances. All of these factors can make it very difficult to recognize the best way to control our money.

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When it comes to debt, you cannot possibly manage your personal finances as though you were a business. Businesses can function, and still make a profit while carrying debt. But if you truly want to become wealthy, you must eliminate your debt. How many times does an investment adviser tell you that the very best investment in the world is to eliminate your debt? On the contrary, you may be advised to use other people’s money (OPM) for investing.
Most financial advisers and planners do not understand the power of debt elimination, and in many cases, their own personal finances are a mess. They can manage other people’s finances fairly well, but they and what happens to such a house when Wall Street takes a tumble? It comes crashing down. People in these situations have a difficult time rebounding, in part due to the immense debt load that they have accumulated and they cannot make any of the payments for their rented lifestyles. Additionally, if you focus on paying off your debts first, you will not have the immediate capital to purchase their services or have money to invest. They neglect to inform you about the true costs of debt.

As an example of personal finances and the costs of debt, consider the following situation:

John and Lisa Philgood (ages 39 and 41) make an excellent combined income of $96,000 a year (the median income for a family in the U.S. today is $41,800). If you were to drive by their house, you would think they are indeed wealthy. They have a beautiful, fully furnished modern house with all of the luxuries and conveniences of today’s society. They have two new cars, and they dress as if they just stepped out of a fashion catalog. To the average person, they appear to be rich.

However, the Philgoods never learned to live within (or below) their means. They purchased most of their possessions on impulse—with credit cards because they wanted their things immediately. They did not wait until they had the cash to pay for many of their purchases. Although they appear to be well off, looks can be deceiving.

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If you were to take a closer look at the Philgoods’ financial situation, you would find that they have $455,000 in assets (hence the appearance of wealth). However, they have $395,000 in liabilities! Their liabilities include a mortgage, a home equity line of credit, $69,000 in consumer debt (which includes a timeshare and negative liabilities on the automobiles, which were purchased new and are not worth what they now owe on them), and an additional $12,000 in credit card debt! This calculates to a net worth of only $60,000—way below the median net worth based upon their age and their income. They appear wealthy on the outside, but they are far from it where it matters the most: they do not have a solid financial foundation. And like most Americans, they have no plan that will give them the power to make any future changes.

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If you took an even closer look at their finances, you would find that the $395,000 in liabilities is from 10 different sources (refer to the table on the next page).

As you can see, the Philgoods are paying $3,662 a month just to service their debt—at a weighted interest rate of 6.93%. Now suppose they are like the majority of Americans and they are simply paying the minimum amount on each loan every month. If that is true, it will take them 28 years and 7 months (343 months) to pay everything off! Additionally, they will pay $384,818 in interest over that time—assuming they will take on no additional debt.

Their debt service ratio is 65.39%, which is their total debt payments divided by their take-home pay. As discussed in the course Financial Planning: Statement Analyses, this ratio indicates one’s ability to cover debts with cash flow (take-home pay). A ratio over 40% usually indicates that one’s cash flow is not adequate to cover their debts. The Philgood’s could be heading for financial trouble.

Now we will examine the Philgoods’ finances from another position. In financial circles, this position is known as a debt-acceleration system. This system will save anyone who correctly implements it thousands of dollars in interest over a financial lifetime.

The method is simple. Minimum payments are made on ALL debts except for one that is designated as the priority debt (the payments for the priority debt are always more than the minimum). Finding the priority debt is determined by dividing the total balance by the monthly payment of each individual debt. The LOWEST division answer becomes your number one priority; the second-lowest becomes priority number two; and so on and so forth.

The priority debt is accelerated (paid off faster) by creating an additional margin of money. The margin comes from supplemental payments previously made on other debt balances and from money created from living a more frugal and sound financial life (as discussed in the Cash Flow Management course). After the first priority debt is paid off, all money (including any margin) that was previously going towards the first priority debt is now rolled into the next priority debt.

Now consider the Philgoods’ finances as they use the debt-acceleration system.

The Philgoods pay the same debt-servicing dollar amount each month ($3,662). However, now they focus on eliminating their debt and not accumulating any new charges. They continue to service their debts (beginning with the priority debt as noted above). Then they accelerate their debt, as one payment (no longer necessary because that debt has been paid) rolls into the next. This gives the Philgoods the power and ability to pay the second priority debt off much quicker. The process continues until they have completely paid all of their debts (including their mortgage) in a greatly increased period of time.

When the department store is paid, the $150 payment rolls into the second priority debt (the AMEX) creating a new payment amount of $200 ($150 + $50). When the AMEX is paid, the accelerated payment going to the Visa is now $220 a month ($150 + $50 + $20); the process continues to accelerate as each debt payment is added to the subsequent debt. With an additional margin added to the equation (created from cutting unnecessary daily expenditures, etc.) the process further accelerates and the overall time frame for achieving a debt-free date is shortened.

In the case of the Philgoods, the benefits of accelerating their debt are outlined below:

• They will be debt-free in 13 years and 1 month (157 months).
• They will have developed the discipline of investing $3,662 every month (in this case, they are investing in themselves by accelerating their debt payments).
• They will save $194,178 in interest payments, which would have gone to creditors.
• They will save 15 years and 6 months (186 months) in paying off their debts.
• They have developed a habit of investing in their debt instead of drowning in their debt.
• If after paying off their debts, they now invest their $3,662 at a 10% compounded growth rate, the Philgoods will have an investment portfolio valued at $1,617,714 (in the same amount of time it will take them to pay off the remainder of their mortgage by making minimum payments).

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Now we shall examine the Philgoods’ finances from another angle—the angle that most salespeople in the financial services industry take: to invest while they manage their debt. Say the Philgoods have an additional $300 in cash flow to invest each month. Do they immediately invest that money or do they invest it into their debts (as an added margin for debt acceleration)? What would you do?

To make this question even more interesting, say that the Philgoods average a 10% return on their $300 a month for the next 20 years. Is this sounding like a great plan with a nice deal of potential wealth? By the end of 20 years, the Philgoods would have $227,811!

However, if the Philgoods take that same $300 a month and invest it in their debt, they will now be debt-free within 12 years (143 months). Moreover, if they continue to make the same monthly investment (at 10%) after their debt is paid, they will end up with a whopping $2,003,788 at the same time they would have been paying their final mortgage payment! That is $1,419,609 more than if they had invested the $300 a month for the same time frame while paying off every last dollar of debt using the conventional payments. Now, what should the Philgoods do? What would you do?

By investing the money now, as conventional wisdom dictates, in 20 years the Philgoods would still have a mortgage to pay and less money in their investment accounts. By adding that additional $300 a month to their $3,314, they are now investing in their debt. Additionally, they are saving $209,672 in interest that would have gone to creditors. Can you think of a better investment?

Conventional wisdom may not seem so wise after all. When it comes to spending, it is often difficult to change our thought processes and years of bad habits. Many of the financial magazines, lecturers, and advertisements say invest, invest, invest; the problem is that people do not really have any money to invest with because they are spending so much of it on managing their debt. They have been programmed by the media to invest rather than eliminate their debt. However, if you invest in your debt first, you will then have real money to invest in the future. You will have the ability and power to build potential wealth.

“Wisdom outweighs any wealth.”
– Sophocles

As previously discussed, wealth is determined by multiplying capital by time and adding knowledge. The more you know about building wealth, the better your position will be to properly invest your capital. The better your position will be to create more wealth!

We often hear conflicting messages on how to manage debt. Unfortunately, we often learn what not to do. We are bombarded by the media, which erroneously teaches us to have it now and pay for it later. We are also taught that having a mortgage is beneficial. Many investors will even counsel clients to go further into debt to pay for investments! Proper financial education should dispel these fallacies, which contradicts sound financial management.

By implementing a debt elimination plan and paying off your debt as quickly as possible, you create the possibility of greater net worth. While you are reducing your debt, you are also creating a more secure retirement. You control your financial destiny. Powered with a sound financial understanding, you can direct your future in any direction you wish to go. Why not make your outlook a wealthy one?

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Drum roll, please. 

1. What is the wealth-building formula?
2. What does each of the elements represent in the wealth-building formula?
3. How does Debt-Acceleration System help you build wealth?

Most of our group these days are Accredited investors with a net worth over 1M and/or make over $250k a year. That said you might be well on your way with a net worth over 250k and/or make $100k a year. If you are any of the above join our club and invest alongside us in real assets. If you are to either of those levels yet you might want to clean up your finances and use this debt elimination system.