How to Succeed When You're in Massive Debt

Whenever the topic of finance is discussed, it is important to note that everyone's situation is different and that financial advice should be tailored to an individual's particular circumstances with the help of a professional advisor.

Everyday our mailboxes are flooded with advertisements, catalogues, and "pre-approved" credit card offers hoping to deplete our savings and draw us deeper into debt. In the latest Survey of Consumer Finances conducted by the Federal Reserve, concern has been expressed that the rising level of debt may become "excessively burdensome to families." Similarly, the American Bankruptcy Institute reports personal bankruptcies are near an all-time high and in 2004, more than 1.5 million were declared.

Debt is a scary place to be; it is emotionally and financially threatening. It limits our ability to meet daily expenses, invest for the future, and creates a long chain of financial difficulties. The strains put on our relationships due to these financial pressures make it imperative that we find ways to effectively deal with debt. Like all problems, it will dangerously compound if we ignore it, so we must confront it head on to positively change the condition of our lives.

Permanently resolving our debt situation involves three things: gaining an awareness of the different types of debt, understanding the psychology and circumstances that led to the current situation, and devising an effective debt reduction, savings, and wealth acquisition plan.

Put simply, debt falls into two categories: investment debt and consumer debt

Investment debt is an obligation that one takes on in order free up funds, generate cash flow, and build wealth. It is the leverage of other people's money (OPM) to purchase assets that substantially increase in value or produce income. A few examples of investment debt include mortgages for rental properties, business loans, and stock margin loans. The best forms of investment debt produce positive cash flow. When debt produces positive cash flow, it generates more money to invest and does not reduce your existing income.

Consumer debt is a financial commitment used to purchase items that have no substantial resale value or depreciate after they are bought. Examples of consumer debt include: automobile loans, personal loans, personal lines of credit, credit card debt, and more. It can be wise to buy an item using consumer credit, if the after-tax return on your investments is greater than the interest rate on your debt. With this approach, you have more money available to invest at a higher rate of return. This is a riskier strategy and should only be employed by sophisticated investors. It is also important to note that one person's consumer debt is another's investment debt. The money one expends servicing debt goes to help another build their wealth. Over time, your goal should be to turn the tables.

The Psychology of Debt

To change your financial condition, you must understand the factors that have led you into debt and position yourself so that you will never return to similar circumstances. Common expenditures leading to excessive debt include automobile purchases, education expenses, vacations, gambling, medical expenses, unsuccessful business ventures, and the frequent purchases of consumer goods and services.

In general, we must become better planners and begin to stop thinking of debt as the first solution to our problems. If our debt situation stems from overspending, we must address the emotional state that drives us to live beyond our means. If it is due to unsuccessful business ventures, we must learn to move our enterprise forward through stock offerings, or creative means like partnerships and the bartering of services. If it is from necessary expenditures or emergencies then we must develop the discipline to create special savings accounts and cash reserves. Once we change the way we think about debt, we are prepared to implement life-changing solutions.

The most expedient way to deal with debt is through a two-tier approach of budgeting and investing.

Begin your financial turnaround by writing down the monthly payment, interest rate, and total amount owed for each of your debts. Once you know where you stand with each of your creditors, attempt to lower your interest rates. This involves calling your creditors and asking for lower rates, transferring balances to lower interest rate credit cards, or more aggressive tactics such as home refinancing, to turn liabilities into lower interest-bearing, tax-deductible debt.

Next, create a realistic budget and eliminate unnecessary expenses. Take any free cash flow and use it to pay more toward your highest interest, non-tax deductible debt. On all other debt, pay only the minimum. Do this every month until that particular high-rate debt is paid off. Once that account has a zero balance, use the money you normally would have expended on your monthly debt payment, plus any free cash flow, to pay toward your next highest interest rate debt. Continue this process until all your debt is paid off.

It is important to note that if you have savings, you should use it to pay down your highest interest rate non-tax deductible debt. It makes more sense to pay off debt at interest rates of 12-18%, than earn less than 2% interest in a money market or savings account. Also, remember the interest rate on your debt is equivalent to the after-tax return on an investment. So, if you are not outperforming on an after-tax basis the interest rate being charged on your debt, it is more advantageous to pay off your debt.

The second aspect of your debt transformation involves investing. In order to effectively manage and overcome your debt, make investments that have a return that outweighs the interest rate on your obligation or that generates cash flow in excess of your monthly debt payment. Because investing can be rather complicated and volatile, it is important that you have as much education as possible in this area. Your first thought may be, "I don't know much about investing, and I don't have the time to learn." Well, you must decide if you are willing to make the time, or choose to work the rest of your life to pay off your financial commitments. Budgeting alone is a much slower solution, so you would be wise to develop a mastery of investing or partner with people who possess such knowledge in order to expedite the process. Seeking the advice of competent professionals is a sound way to shorten your learning curve and prevent costly mistakes. If you encounter an emergency during this period, you may use your credit accounts as your cash reserve.

There are many strategies for investing your way out of debt. Some include starting or investing in businesses and buying assets that appreciate in value or generate cash flow. The issue becomes, how do you take advantage of opportunities with little cash and poor credit? The answer to most questions of lack is through partnerships. Though we may not view ourselves as entrepreneurs, we all have viable business ideas inside us. It is up to us to develop those ideas and approach enough people until we find partners who believe in us and are willing to finance or actively participate in our venture. For those who like the idea of owning their own business, but not the hard work it takes to develop one from scratch, there are a number of direct sales organizations that will provide you with business opportunities for low startup up costs and lots of guidance. All of these add up to ways of generating excess cash flow to help pay off your debts and build wealth.

The mentality that created your current financial situation will not suffice to solve your debt issues. For most, the financial difficulties we face have taken years to develop, so they will not be solved overnight. As much as we would like to believe, there are no incantations or magical formulas for ridding ourselves of financial obligations, only the disciplined strategies of sound money management and investing. We must remember to deal with the issues that drove us into debt before attempting to implement any strategy. If we do not start with our own thought process, any plan of action will not be effective in the long-run and may put us in a worse financial position. To transform our lives, we must change the way we think about finance and obligations. On the occasions that we do use debt, it should be for the purpose of buying assets, not consumer goods that depreciate or have no value.