What impact does my debt have on my financial situation?
For many of us, debt is a huge part of our lives. In fact, the table below shows typical debt balances, as well as total debt balances owed by consumers, according to NerdWallet’s 2017 American Household Credit Card Debt Study.
As you can see, our lives are dominated by debt. Of the types listed above, credit card debt is usually the worst. The others typically have much more reasonable interest rates and correspond to an equally valuable asset. The exception would be student loans, where the corresponding asset is a human capital component. Ideally, taking on student loans allows you to pursue higher education to obtain a better career and a higher salary to go with it. That is one of the greatest financial assets we can cultivate.
Ultimately, debt serves a very important purpose in just about everyone’s lives, but it’s important to use it wisely and use proper strategies to pay it off.
What should I do before deciding on a strategy?
There are a couple steps we need to take before we dive into different debt reduction strategies.
1. Organize all of your debt – Gather all the necessary information on your current debt. This includes current balances, remaining terms (how long you have to pay it off), minimum monthly payment amounts, and interest rates (fixed or variable). This is all information an advisor could use to put together a payoff schedule for you.
2. Look at your cash flow – The next step is to ensure that you are budgeting properly and have the cash flow to afford the minimum payments, and ideally, a little more. If you are not budgeting properly and/or cannot afford minimum payments you should seek out a debt counselor to help you get these areas under control.
What strategy should I use to payoff my existing debt?
Once you know all there is to know about all of your debt, and you have the capacity to begin working towards paying it off, it’s time to talk strategy. The largest variable in any debt paydown approach is the order in which to attack your various loans. This brings us to the “Snowball” strategy. If you haven’t heard of it, it suggests paying off your smallest loans first, then applying that payment amount towards the next smallest loan, leading to a larger and larger payment on subsequent loans. It has gained popularity primarily because it is simple and feeds into positive psychology. We see ourselves doing more good, more often, if we pay off the smallest loans first. This encourages us to continue the debt snowball effect until all loans are paid off.
While there is nothing inherently wrong with this approach, our job as financial advisors is to give you the best advice that will help you the most in the long run, while keeping your goals, values, and priorities at the forefront.
This brings us to what I’ll call the “Titanic” strategy. Debt is a lot like a sinking ship, where the interest rates of various loans act as the leaks in the hull, and the water is the actual accrued interest. To stop the sinking, you have to plug the holes as quickly as possible. But which holes would you plug first? Logically, you would want to plug the holes that are letting in the most water. Similarly with your various loans, you should put any extra payments towards the highest interest loans first.
The simplest and most effective approach is to take a list of all your debt, sort first by interest rates, then if any have similar rates, sort by balance remaining. This will allow you to prioritize the highest interest, lowest balance loans first. Then you can create a similar snowball approach by adding that payment to the next loan in line.
Any exceptions to this strategy?
There is an exception to every rule. In this case, it’s minimum payments. We started by explaining you should be in a good cash flow position to begin paying off debt aggressively. Even for those who are, you may find greater comfort in using the debt snowball strategy to eliminate minimum payments as early as possible, thereby increasing your free cash flow (cash flow that doesn’t HAVE to be put towards bills). For example, if you have three loansThis is a case where your comfort and peace of mind could hold greater weight than the financially optimal “Titanic” strategy.
Ultimately, your goals, values, and priorities should drive the direction of your financial plan, including your debt management. If you have a complex debt situation and need someone to help you develop a strategy that meets your goals and improves your financial fitness, please contact me.