Are you struggling with debt? Well, we here at ChooseFI are here to help with our guide to debt! Debt is a major hazard to your goals, even if you are well on your way to Financial Independence.
If you are here, you are not alone: the average American is just north of $90,000 in debt. Now this includes “good” debt and “bad” debt (don’t know the difference? Stick around!). Feel a little better?
This guide will show you everything: from the types of debt you incur, the ones that are the most toxic, and how to knock them all out. We’ll also discuss economics, personal finance, psychology, and money management (among other smaller details). We’ll also guide you through the different steps to tackle debt that are most comfortable to you. Thought you just had to shove your entire paycheck into a black hole of never-ending nothingness? Think again.
So sit back, relax, and grab snacks. This debt guide is a long one, but oh so worth it!
- What Does It Mean to Be In Debt?
- Guide to Debt: Brief Overview of External Factors of Personal Debt
- Important Guide to Debt Terminology
- What Are the Main Types of Debt?
- What Is the Difference Between Debt and a Loan?
- Good Debt vs Bad Debt (In A Time Capsule)
- Guide to Debt Takeaway
- Debt-to-Income Ratio
- Credit Reports
- Credit Scores
- Guide to Debt Outlier: Student Loans
- Guide to Debt: How To Get Out of Debt Quickly
- Guide to Debt Big Payoff: The 3 Ways You Can Destroy Debt
- What Is Catastrophic Debt
- The Bottom Line
What Does It Mean to Be In Debt?
In simple terms, to “be in debt” means that you owe someone (typically a business or other entity) money. This usually means payments for goods and services. Standard examples of debt are car payments, medical bills, student loans, etc.
However, modern terminology has modified “to be in debt” as to “to be in over your head in debt.” Meaning you do not have the money to pay off your debts each month, putting you at a financial disadvantage.
We are here to give you the tools in this guide to “get out of debt” as quickly and cheaply as possible.
Guide to Debt: Brief Overview of External Factors of Personal Debt
There are several external variables of the economy that affect your personal debt directly. We are going to look at two that matter most. This will give you a clearer idea of how the national debt (clocking in at about $28T) affects your personal debt and spending.
Trade deficits: a trade deficit is when a nation’s imports exceed its exports. Why does this matter to your debt? Because when the deficit creates overstock in products it leads to a product surplus, which then leads to non-payment of goods, which finally leads to a debt spike. When “big business” has a spike in debt, you have a spike in debt. It ripples throughout the entire economy.
But your debt doesn’t change, so why a spike? Interest rates increase, therefore your debt increases (think 19% APR rising to 22% APR). Also, purchasing power decreases for consumer goods because eventually, this process leads to goods being produced abroad (instead of domestically). Therefore you pay more for everyday goods, making your available funds to pay down debt decrease.
Inflation: inflation decreases the value of the dollar, theoretically making it easier to pay down debt; however, with a weaker dollar, a spike in national debt occurs if national wages stay the same (which they almost always do). So, similar to a trade deficit, if your personal wages stay the same during increased inflation, it’s harder to pay down debt.
Example: inflation is 3% on average. This means your dollar buying power falls by 3%. Unless your wages increase by 3%, you have less purchasing power (not less money). Nonetheless, the outcome is the same as if you did have less money.
Important Guide to Debt Terminology
Here is a list of terms that you need to know for this guide:
Bankruptcy: Chapter 7: a complete clearing of all debts owed (except student loans, tax liens, and child support). You also must liquidate all assets you own, with the exception of some (determined by the state you live in).
Bankruptcy: Chapter 11: also known as “reorganization” bankruptcy, is usually applied to small organizations and partnerships. Unlike Chapter 7, assets can still be held if proper negotiations are held and a repayment agreement between the filer(s) and the loan holders is reached.
Bankruptcy: Chapter 13: for those with massive unsecured/secured debt, yet want to keep their assets. The debt limits for Chapter 13 run $420,000 unsecured and $1.26 million secured (e.g. house). The debtor has 3-5 years to pay back on a payment plan and must prove enough income to do so.
Charge-Off: when a lender cannot collect the money a debtor owes against their outstanding balance, a charge-off can remove the outstanding debt from the lender’s books as a business expense.
Collateral: an item of value that is “put up” to secure a loan. If the loan is not repaid during the loan repayment period, the issuer of the loan may take ownership of the collateral.
Collections: when an outside company purchases your charged-off credit card debt or other forms of debt (e.g. cell phone debt) for pennies on the dollar. They then pursue the debtor to pay off the debt at a “discounted” rate.
Credit Report: a comprehensive report of all your past and current debts. It reflects if you paid on time when the account was opened and closed, and various other data regarding your creditworthiness. Check these frequently to ensure your debts are properly tracked. Our guide to debt will give you the proper guidance to credit reports.
Credit Score: a score that ranges from 300 – 850, it is what companies use to determine your creditworthiness. It works in tandem with your credit report to inform lenders of how likely repayment of your debt will be. The higher the number, the more likely you’ll be approved for a loan or a credit card.
Credit Utilization: how much of your extended available credit you are using. This makes up about 30% of your credit score.
Debt-to-Income Ratio (DTI): your Debt-to-Income ratio. Measures how much income you bring in per month against how much outstanding debt you owe. To determine your DTI, you must:
- Calculate your monthly bills
- Divide by your gross (not net) income
- The difference is your DTI, expressed in a percentage
- Example: Total bills = $8000; gross income = $10000; DTI = .8 or 80%
DTI ratios are incredibly important to lenders. It gives them a snapshot of your ability to pay back loans. DTI ratios are used to determine anything from car loans to mortgages.
Disposable Income: how much money you have after paying for all required expenses, household or otherwise.
Equity: how much money you have vested in your home or the value, in dollars, you have from your home. Equity is earned during your mortgage term and comes to a full vested balance (100% ownership) when your mortgage is paid off.
Interest Rates: how much interest or percentage of your balance is charged to you, for having an outstanding balance from a loan or credit card. Always expressed in percentages and the terms of the rate follows that percentage (e.g. 19% APR or 19 percent; annual percentage rate).
Minimum Payment: in order to keep your debt current. It’s critical to keep your revolving debt current and to make all minimum payments to avoid countless penalties and other fees.
Predatory Lending: any loan or revolving debt that is abusive and unfair to the borrower. Unfair practices include short repayment windows too far beyond market interest rates.
Principal: the base amount borrowed – this could be for a loan or an initial credit card balance. The principal is what you actively borrow. Interest occurs against any principal; whether it be a one-time purchase (e.g. car purchase) or revolving balance.
What Are the Main Types of Debt?
Secured debt has collateral (something of value) attached to the debt. So if you default, the bank or whoever holds the debt can liquidate your collateral to get their money back. The best example of these today is secured credit cards. They require an upfront deposit (usually around $200 – $500) and then they’ll issue a card. These are good for those rebuilding their credit and want to boost their credit score.
The best example of unsecured debt is your run-of-the-mill credit card. Almost all credit cards, except for secured cards with “retainer” collateral, are unsecured. This is why APRs are so high for mid-range credit score holders. The better your credit score, the better your APR (usually). Unsecured credit cards are a large risk for banks – so these days a credit score of 600 may not get you a great unsecured card like it could 15 years ago.
These include credit cards, but also Home Equity Loans (HELOCs), and personal lines of credit. They have a payment schedule where payment is due on the same date of each month and must be made in full in order to continue using the line of credit. If you are late or you do not pay the minimum amount, you may suffer consequences depending on the terms of the debt.
The “best” debt you can have. A mortgage is a line of credit that you take out from the bank to pay for your house. When you start paying your mortgage, some of the money goes towards interest and some goes towards the payment of the house. This is called equity. Generally speaking, the more you pay on your mortgage, the more equity you have in your home.
What Is the Difference Between Debt and a Loan?
We will dive further into this, but since this is a common question we’ll address it now in the guide: debt and loans are closely tied together. To break this down for you in consumer terms:
- Debt is the total outstanding money that you owe. This could be to the dentist, to banks in the form of credit cards, or any promised money to a person or organization.
- Loans are a form of debt that have specific repayment rules that you must follow. Personal loans often carry higher interest rates than a car loan, as the car is “acting collateral” for the loan. Meaning, a personal loan has no true collateral attached.- therefore there is more risk to the bank. A car loan is secured with the vehicle If you don’t pay your car loan, it could be repossessed (or reclaimed by the seller).
Good Debt vs Bad Debt (In A Time Capsule)
We’ve all heard this one before – what makes a debt “good” and what makes it “bad.” Hate to disappoint you, but the answer has become incredibly subjective over the years.
Good Debt vs Bad Debt Then (30 years ago)
Let’s go back to 1990. The lines were relatively clear when it came to “good” and “bad” debt:
1990 Good Debt: Mortgages, student loans, investments with a promise of a small, solid return (e.g. cars without too much depreciation, durable goods like appliances).
1990 Bad Debt: Consumer loans (i.e. want that stereo?, purchase price + 17% APR), high-interest credit cards, overextension of salary leading to installment loans for the necessities.
Good Debt vs Bad Debt Now (21st Century)
So what makes a loan good or bad in 2021? What is the result of borrowing money in order to purchase goods or services? Are those goods and services worth the price tag?
Unfortunately, the answer is just as subjective – just in a different way. A college education doesn’t hold as much weight as it once did. “Durable” goods that last 5-10 years have fallen victim to planned obsolescence.
Let’s look at some additional, current examples of “good debt” and “bad debt:”
Student loans are a controversial one in the 21st century. Student loan debt makes up $1.7T of the federal debt: the single largest chunk. It could be argued that those with college degrees have a better chance of getting high-paying jobs. However, specialized programs that teach a specific skill (usually in the IT or medical industry) are quickly taking the place of the 5-figure price tag of a university degree.
So is a Student Loan debt “good” or “bad?” In this debt guide’s instance, you be the judge.
So, what are the downsides? A mortgage is a massive commitment, even in a bullish housing market. You may be locked into a piece of property that you aren’t fond of after a few years. And, although the value of your home may go up, we all remember from the 2008 housing crisis that there is no unbreakable bubble.
Bad Debt (the following are the most toxic debt you can carry)
High-interest credit cards – generally speaking, those with poor to fair credit have an average of about 25% APR on their cards. So if you carry an unpaid balance, you pay a quarter of what you borrowed. You cannot achieve FI with this type of toxic debt.
The worst of it is that this is revolving debt – probably being carried for years. Don’t worry, we’ll guide you through how to destroy this debt toxicity on your path to FI and not make the same mistakes again.
- Personal loans: the first thing that should be said about personal loans, on the path to FI, is that you should never borrow money to purchase a luxury item until you have the money to pay in full. However, say you are stuck paying for a tennis bracelet you’ve been paying on for several months that maturties in a year. The interest rate will be at least in the high teens and could even reach mid-thirties.
- Payday loans: an incredibly toxic financial tool that can get you in major trouble. Payday loans promise you an advance on your paycheck, but they do so at an astronomical cost. Taking out a payday loan requires you to not only pay back what you borrow, but at an insane interest rate (typically 400%) and is due 14 days after you take out the loan. Payday loans also can trap you in a cycle of debt, considering the interest you have to pay back. You could rely upon them if you take one out due to the amount you have to pay back. They are predatory lending – pure and simple.
Debt Guide’s Result of Bad Debt
The accrual of interest is what results from bad debt. Pure and simple. Getting immediate satisfaction from purchasing an item that allures you could literally set your path to FI back six to eight months; if not longer
Guide to Debt Takeaway
Although still subjective, there are some logical rules in play. Is it important for your child to go to college to obtain the dream job they want? Are you willing to sacrifice “more home” for “more equity?” These are important questions you need to answer as a family to navigate your path to FI and mitigate debt in 2021.
Those on the path to Financial Independence must make disciplined decisions about their spending. This includes your discretionary spending. We afford what is important to us. If you want a nice car, buy a nice car (if it fits your budget!). But, budget for it thoroughly – including the potential repairs and maintenance. That is how you reach FI – plan for everything!
Another important financial formula that lenders will look at is your Debt-to-Income Ratio (DTI). This is calculated by adding up all your debts (NOT including everyday expenses like groceries or utilities) and dividing them by your gross income. The result is your DTI – expressed in a percentage.
Guide to Debt: Hypothetical Example
Your debts include (per month):
Rent – apartment: $1,000
Car loan: $450
Student loan: $100
Credit card #1: $80
Credit card #2: $50
Personal loan: $200
Note – when calculating credit card payments, use the minimum payment due.
Monthly debt total: $1880
Gross income per year: $65000
Gross income per month: $5416.67
Your DTI is: 1800 / 5416.67 = .332 or 33.2%
What is a Good DTI
A “good” DTI is below 36%. Your DTI itemizes your debts and your income, giving the lender a better idea of what you are spending your money on and how many incomes are under each household. Yes, they’ll do anything they can to get all the information they can before lending. Those on your path to FI are already well aware of this “fun fact.”
Yes, another popular lending snooping tool. Credit reports are used for everything from “smaller” extensions of credit like credit cards to used car loans. to larger loans (new car, mortgage).
Your credit report is a qualitative and quantitative report of your finances. Qualitative means “not calculable” – more about the characteristics or qualities or the loans you have. Quantitative because it does track how many times you make a payment on time, if you paid off a loan, what was the total payoff, and how much outstanding debt you have.
You should understand a few things about your credit report. First is that there are two types of “pulls” on your credit report: hard and soft.
- Hard pulls affect applications for a loan or a credit card. This alerts the reporting agencies that you are seeking credit. If you apply for too many extensions of credit, it can really hurt your credit score (we’ll talk about that in a second). One hard pull decreases your credit score by a little. Several consecutive pulls decrease your credit score significantly.
- Soft pulls are when you request a copy of your credit report. Per federal law, you are allowed one free copy of your credit report every year from each of the 3 main credit reporting companies. Please take advantage of these credit reports as they can truly help you if someone has stolen your identity or a company has incorrectly reported a payment. Soft pulls are also used by credit card companies to determine if you are pre-qualified for a credit card. Getting a lot of “pre-qualified” credit card offers in the mail? You have soft pulls to thank for that. The good thing about soft pulls is that they do not affect your credit score in any way.
Credit scores are the heart and soul of scoring a new credit card with tons of perks. Each score ranges from 300-850. The higher the score, the better your chances are of getting a low APR on a car loan to a credit card with premium advantages.
Your credit score composition can change from year to year, but roughly follows this combination and weight of factors:
- Payment History (if you pay on-time and make the minimum payments) is about 35%
- Amount Owed (how much of your extended credit you are using) is about 30%
- Credit History Length (the age of your first extended credit line to present) is about 15%
- Your Credit Mix (do you have a variety of credit extensions – like car loans, credit cards) is about 10%
- New Credit (how many of your credit extensions are new – usually within 3-6 months) is about 10%
How do you calculate this score?
Because FICO (the Fair Isaac Corporation) has a proprietary scoring system that uses the above weights applied to your specific credit history, a member of the general public cannot accurately calculate their score. The only way to get your current score is to go to myFiCO.com and submit a request (plus a fee of about $25).
What is a Good Credit Score
According to credit.org, a “Good” credit score ranges from 680-739 and an “Excellent” credit score ranges from 740-850 (with a median US credit score of 722). These scores will land you the best APR rates for loans and credit cards. If your score is lower than 680, chin-up; you can improve your score by making better decisions regarding your credit and paying off your debts. That’s the good thing about credit scores: they don’t define you. And don’t let them define you. There is always a way to improve. And soon we’ll show you the best ways to tackle your debt in this guide.
Guide to Debt Outlier: Student Loans
Student loans are an outlier when considering credit eligibility and repayment options. We’ll try to keep it simple as it can be rather complex when considering Department of US Education issued loans and private student loans.
First, why are they an outlier when considering credit eligibility? Because they have little impact on your credit score. They are considered installment loans, like car loans and the like, but only really come into play if you do not make payments on time or if you are in default. Then they can put your FICO score in the tank.
But, there is a lot of flexibility in student loans, especially those issued by the Department of Education. You can request forbearance for virtually any reason to delay repaying. You only have two years of forbearance allowance, so use it wisely.
Student loans also have a repayment structure that is incredibly unique. You can request an IDR (Income-Driven Repayment) plan if you cannot afford your payments. There are several IDRs to choose from. According to studentaid.gov, there are 4 different IDR repayment options. The most you’ll pay under any of these repayment options is 15% of your discretionary income (which is defined by your income after taxes and essential household items are paid for). This is a huge upside to those with massive student loan debt (considering the average student loan debt is about $30,000 for those with a bachelor’s degree). The only caveat to the IDR plans is that you have to recertify your annual income each year.
Private Student Loans
Unfortunately, if you have private student loans (those issued by a bank, not the DoE) you do not have the flexibility of IDR repayments or any type of loan forgiveness. They are issued based on your credit score and ability to repay (which is why many are co-signed by a parent). The problem with this is that these loans are treated as regular installment loans. So, if you have borrowed $40,000 with a generous APR of 5% for 10 years, you’ll owe approximately $450 per month (netting the bank about $11,000 in total interest). As you can see, this isn’t the greatest deal for recent graduates.
The Big Rub for Both Federal and Private Student Loans
There is one huge issue when it comes to all student loan debt, public or private: neither is eligible for bankruptcy protection. This means if you owe $100,000 in student loans, that $100,000 debt never goes away. Even if you default, the government and the banks have the ability to garnish your wages (federal 15%; private 25%), seize tax returns, and destroy your credit report and score. Missing just 30 days on your student loan can knock your FICO score down 100 points. The bottom line to take from this debt guide: pay at least the minimum on your student loans.
Guide to Debt: How To Get Out of Debt Quickly
Bad spending habits are usually why we fall into debt. Putting everything on credit cards (the things you can’t afford), not using disposable income to purchase items that are wanted not needed, and essentially overspending.
Simply put: there is no “fast” and “cheap” process to grind out of debt; however, there is a painful and unpleasant process.
“Chains of habit are too light to be felt until they are too heavy to be broken.”-Warren Buffett
The Process of Digging Yourself Out of Debt
In order to get out of debt the “fastest” and “cheapest” way, you’ll need to do the following:
- Keep track of all expenses. These are essential expenses and “extra” expenses.
- Find all unnecessary expenses and stop this spending.
- Cancel unnecessary expenditures, such as extra cell phone perks. These are not necessary expenses, no matter what your kid says. And, if you want to save on your cell phone bill, check out our review of Mint Mobile.
- Create a budget for your essential spending and utilize the rest of incoming cash flow to pay down debt. *We will get into debt payoff strategies further in the guide that we promise are more reasonable and not as painful, so stay tuned.
- Pick up a side hustle. This could be anything from selling stuff you don’t need anymore on eBay to getting on a contracting site like Upwork.com and pick-up a second job. For more ideas on side hustles, check out our blog on short-term side hustles or listen to the guys talk about finding your side hustle idea.
- Negotiate: everything from a better interest rate with your credit card provider to lowering your medical bills. Everything is negotiable and the worst they can say is “no,” so start calling. Need motivation? Listen to the guys talk about negotiation.
- Stop overspending. This is everything from too many trips to the mall to retail-therapy online. These dollars will serve you better in the long-run in investing or paying down existing debt. Check out our spending less blog here.
Guide to Debt Big Payoff: The 3 Ways You Can Destroy Debt
These 3 proven ways have helped millions get out of debt. And frankly, it’s truly a mix of psychological and mathematical approaches. We’ll take each method in this debt guide; explain in plain terms how to utilize it, and the positive psychological effects from each one – so you can make the decision on which of the 3 work best for you.
Hypothetical Debt Load Example:
In order to properly show you how each of these debt elimination methods works, we’ll need to set up a hypothetical debt load so you can see how each attacks the same set of debt amounts and APRs.
Say you have:
Credit card with a minimum payment of $110 per month at a 16% APR and a balance of $4,100
Credit card with a minimum payment of $200 per month at a 21% APR and a balance of $6,700
Auto loan with a minimum payment of $300 per month at a 5.9% APR and a balance of $4,500
Personal loan with a minimum payment of $15 per month at a 19% APR and a balance of $95
Student loan with a minimum payment of $220 per month at a 6.9% APR and a balance of $27,800
The Debt Avalanche is the most mathematically effective approach to eliminating your debt. It works by ordering your debts from the highest interest rate to the lowest interest rate. This will eliminate the “heaviest” interest load on you first and proceed with the next and next until finished.
How it Works
Let’s order our debts by highest to lowest interest rate:
Credit card with a 21% APR
Personal loan with a 19% APR
Credit card with a 16% APR
Student loan with a 6.9% APR
Auto loan with a 5.9% APR
OK, now that we have all of our debts in APR order, we attack the first credit card (with the 21% APR) with both barrels. Sell anything that you possibly can. Pick up a second job. Get a couple of side hustles to get as much additional income as you can.
By assaulting the first credit card with every dollar you can throw at it, the lower the balance will decline each month. The rest of the debts we simply want to keep alive by making the minimums.
The result will be that the first credit card with the highest APR will be paid off much sooner than you could have expected. Trust us. By eliminating all other wasteful spending and putting it all on one card, it will vanish before you know it. Once you’ve eliminated that card, you’ll move on to the personal loan – as it has the next highest APR. Rinse, repeat until you have eliminated all your debt.
The Debt Avalanche may seem painful at first, but being debt-free and so much further down the path to FI will feel so much better than the sacrifices.
Have you had personal frustrations with paying down debt? Feel like you aren’t making any progress? If this is you, the Debt Snowball method should be your plan of debt attack.
The Debt Snowball may seem counterintuitive at first, but it is a stronger positive psychological approach to attacking debt than the other methods. This will be more encouraging to see debt categories disappear faster and give you momentum in knocking out the rest.
How it Works
Let’s order our debts from smallest balance to largest balance (regardless of APR and minimum payment).
Personal loan with a balance of $95.
Credit card with a balance of $4,100
Auto loan with a balance of $4,500
Credit card with a balance of $6,700
Student loan with a balance of $27,800
With all our debts in order of balance, we take a similar approach as the Debt Avalanche: attack the first balance (the personal loan in this example) with the same veracity (keeping only enough behind to pay the minimum balances on the rest of the debts).
As you can obviously see this method will knock out specific debts faster than the Avalanche; however, our goal is not to “play” the optimal mathematical strategy. The Debt Snowball is psychologically positive. As you see more and more of your accounts fade into pay-off oblivion, you gain a sense of accomplishment and momentum.
The Debt Hybrid method is just that: a blend of the Debt Avalanche and the Debt Snowball. It takes into consideration knocking off small debt balances first (Snowball psychology) then organizing the rest of your debts by the highest interest rate to lowest (Avalanche mathematics).
The goal is to take the best of both worlds. Knocking off small balances (regardless of interest rate) for psychological momentum and then attacking larger debt balances by highest interest rate first for optimal mathematical results.
*For the Hybrid, we will use a different set of debt examples to better show the Hybrid impact.
Credit card with a balance of $900 and an APR of 18%
Credit card with a balance of $1,100 and an APR of 23%
Personal loan with a balance of $550 and an APR of 17%
Personal loan with a balance of $2.300 and an APR of 21%
Auto loan with a balance of $5,000 and an APR of 4.9%
Student loan with a balance of $35,000 and an APR of 6.9%
How it Works
We want to get a positive psychological start with the Hybrid method, so we will be applying the Snowball methodology for the smallest debt balances. In our case, these will be the two credit cards and the first personal loan. We will arrange these from smallest balance to largest.
Personal loan with a balance of $550
Credit card with a balance of $900
Credit card with a balance of $1,100
And, again, just like the Snowball methodology, we attack the first loan with all the dollars we can. Keep in mind that the rest of the accounts, including the ones not ranked yet, have to have their minimums met. So don’t use all expendable income on the personal loan. Rinse, repeat until we have paid off all 3 of these accounts.
With the smallest balances paid, we move to the larger ones and apply the Avalanche methodology. So let’s rank the last 3 accounts we have on our books from highest APR to lowest.
Personal loan with an APR of 21%
Student loan with an APR of 6.9%
Auto loan with an APR of 4.9%
Pay off the first personal loan. Then finish off the final 2 accounts. Even though we didn’t hit the highest of all of our APRs with this method (we destroyed some in the Snowball phase) we get a ton of value mathematically from paying down these loans using the Avalanche.
We were able to gain momentum by knocking out our smallest accounts first and maximized our value by polishing off the larger balances using optimal strategy.
Listen to the guys as they talked to Deanna on the podcast about how this hybrid approach was conceived.
What Is Catastrophic Debt
You’ve heard the phrase “no one plans for a car accident.” Unfortunately, there are times when even the best financial planners hit hard times or suffer a negative life-changing event (a car accident that isn’t covered by insurance, life-threatening illness). These are catastrophic events. And catastrophic events can lead to the draining of your emergency fund, your liquidity, even the equity in your home… And catastrophic events can lead to catastrophic debt; leaving you no other choice but to declare bankruptcy,
Bankruptcy, especially those on the path to Financial Independence who have a good idea of how our finances work, is an absolute last resort. Not only does it destroy your finances, but it also reverberates throughout your life: from not getting looked at twice for any credit card for years, to trouble finding employment, to losing your home.
But, say it’s the only option in the chamber. Here is an overview of the 3 types of bankruptcies you’ll probably encounter.
Bankruptcy: Chapter 7
Also colloquially known as “liquidation” bankruptcy, Chapter 7 involves the discharge (forgiveness) of all unsecured debt. Although this is the most “popular” form of bankruptcy, it is also arguably the most damaging if you own any assets (including vehicles above a certain value, homes, property).
You are allowed to claim “exemptions” under Chapter 7, which protects some assets from being sold. These may include your primary vehicle (if fair value is low enough), your primary residence (although there is a lot of red tape involved and even then exemptions may not save it), among other assets. Bankruptcy law varies from state-to-state so there is no size fits all that we can give.
Bankruptcy: Chapter 11
Also referred to as “reorganization” bankruptcy, Chapter 11 is usually reserved for businesses (like LLCs). The debtor is allowed to continue business operations through Chapter 11 filings only after approval from the courts.
We include it here because many on the path to FI are small business owners and you should be aware that Chapter 11 exists. However, it is notoriously known for not only being incredibly complex but also very expensive. Further, creditors have quite a bit of control over proceedings. Determining if Chapter 11 is the best option for your small business can have a complex impact on both your personal and professional financial state and is best done in consultation with a skilled professional, such as an accountant or bankruptcy attorney.
Bankruptcy: Chapter 13
Like Chapter 11, Chapter 13 is also known as “reorganization” bankruptcy but is only available for individuals. You’d file Chapter 13 if your debts were simply out-of-control and could not make minimum payments each month.
Chapter 13 also shares similarities with Chapter 11 in that it is a complex and expensive process. Repayment programs can last 3-5 years. There are also income limitations and outstanding debt limitations. Tread carefully when thinking about filing Chapter 13.
There is a reason why Chapter 7 is the most popular form of bankruptcy: it’s relatively simple to file and there are very few restrictions on who can file. Chapter 11 and 13 usually price businesses/individuals out of filing. The bottom line is that no matter which option you choose, your credit will be basically useless for at least 3 years and can last up to 10 years. This is why it is your last resort.
The Bottom Line
We’ve covered a lot of ground in this guide to debt. Our goal is for you to be as forewarned and as forearmed as possible regarding debt as it is a massive drag on your finances, thus your path towards FI.
Obviously, the best advice we can give is to stay out of debt, but unfortunately, debt is a part of life. You need it to buy assets you need and would need incredible liquidity that even the savviest investor probably doesn’t have. So, always know what you are getting yourself into. If you are buying a home, do a ton of research and shop around for the best mortgage before committing. Buying a car? Strongly consider buying used as the devaluation of new vehicles is a real thing and used cars are always less expensive.
Most importantly, do not overextend yourself financially for items you should be purchasing with disposable income. Remember, passing up on that new TV can mean more money in your investment accounts.
Choose wisely and keep your debts at a minimum. Debt can be a tool that when used appropriately can accelerate one’s path to Financial Independence, but when used recklessly can hinder it.
“Some debts are fun when you are acquiring them, but none are fun when you set about retiring them.”– Ogden Nash