New Year's Resolution: To Become Debt Free

Dear Accounting Professor:

My New Year's Resolution is to become debt free. What advice can you share with me?

So Broke That I Cannot Afford to Pay Attention


Dear Broke:

I recommend that everyone who wants to become debt free establish a benchmark for their current financial condition. This involved creating a detailed list of all of debts and assets. Some examples of debts include credit cards, lines of credit, signature loans, student loans, mortgage payments, car loans, payroll advances, unpaid medical bills, etc. Some examples of assets include cash, checking & savings accounts, money market accounts, brokerage accounts, retirement accounts, cars, homes, etc. For asset valuations, one has to use objectively reasonable fair market valuation sources less any fees to determine a net realizable value. Examples of these sources include the most recent close price for a stock less any transaction fees, Realtor.com's selling estimate for a home and then reduce that value by 10% because of closing related costs, etc.

If the difference between the total net realizable values of the assets (as if these were immediately liquidated today) and the total debts owed is positive, then a person has a net worth. If that difference is negative, that person's financial health is insolvent (meaning possibly bankrupt). There are two ways to increase net worth. One is to eliminate debts and the other is to increase the assets. Since life is unpredictable and, at any point in time, our ability to earn an income that would allow us to increase our asset base, it is a wiser strategy to focus on eliminating debts quickly. Ideally, we want to increase our income at the same time that we are eliminating debts.

Debt elimination serves to reduce our long-term expenditure needs, which allows us to financially survive on a lower income level should life happen and our income be reduced (or eliminated) for a period of time. Maintaining the current debts is financially unwise because our income levels this year are not guaranteed to remain the same in future years. (This is true even if our income stream is guaranteed by a government agency.)

To prioritize which debt needs to be eliminated first, I recommend dividing the debts into two categories: 1) debt that has no tax savings benefits and 2) debt that has a tax savings benefit. Both of these categories needs to be divided again into two categories: a) unsecured debt and b) secured debt. Debts in these categories should be eliminated in the following order: 1a, 1b, 2a, and 2b with the elimination priority within each category being the highest effective interest rate before the lowest effective interest rate.

Every six months (e.g. January 1 and July 1), I recommend that you conduct a financial census to evaluate your progress. Doing this every six months serves to remind you of your goal. If you can, find someone who you trust that can hold you accountable for your financial decisions that impede your ability to achieve your goal. If you want a detailed road map to financial freedom, you can always hire a financial advisor to create one for you. (I do this for my clients.)

I wish you great success with achieving your New Year's Resolution.

Comments

Popular posts from this blog

Financial Risks For Retirees

Should I Start a Small Business?