This post contains references to one or more advertisers. I may receive compensation from our advertising partners. All opinions in this post are my own and have not been reviewed or changed by advertisers. One of the most common and least interesting debates in personal finance is whether you should use the debt snowball or the debt avalanche to get out of debt. Here's a summary of the debate: Team debt snowball tells you that you should pay off your debts smallest balance to largest balance. The psychological boost that you receive from paying off the small debts will motivate you to stick to the debt payoff plan. Team debt avalanche says, "You fools." Math indicates that you should payoff the highest interest rate first. That way you'll pay less over time. Why do we waste so much time on this debate? The reason is that we can see that some plan is better than no plan. It's much better to focus on debt payoff than to pay a little bit off here, and a little off there. However, isn't even better to make a tailored plan that will work? One size fits all debt payoff plans don't work. Instead of assuming that your favorite type of frozen water will work for everyone, let's get a little bit smarter. This is a guide to making your own debt payoff plan that will work for you. Step One: Ask Why am I in debt?Before you make a debt payoff plan, you need to face the music. Ask, "Why am I in debt?" Be gentle with yourself, but be truthful. Here are some common answers. Many people are in debt because of sudden and traumatic life events. An accident or illness can force a person out of the workforce and cause their medical bills to pile up sky high for a few months or even years. Perhaps your business failed (or even succeeded), but you financed the entire startup on 18% personal credit cards. It's now common for people to start their career with five figures or more of student loan debt that may or may not tie to their employability. Some people get whacked with frequent minor emergencies that land them in credit card debt. Other people look like they have frequent minor emergencies, but they've just failed to plan ahead. Some people fritter money away and wind up in various types of debts. Still others think they can live like a fancy person on an unfancy income. Maybe an employee embezzled funds, or maybe the market for your company suddenly evaporated due to disruptive technology or legislation. Should all these people with different stories all approach their debt payoff the same way? I think not. If your story involves a behavior that you should change, that needs to be a big part of your payoff plan. But you need to know first. Step Two: Diagnose what you would do differently ThHindsight is 20/20, so use the benefit of perfect vision to say what you would have done differently. Would have spent less, perhaps implementing a budgeting system. You may wish you hadn't gone to college or to get that second degree. Perhaps you would set aside a little money each month so that you don't have to deal with little emergencies every month. Maybe you would have purchased disability insurance, or maybe you wouldn't have listened to your heart when you hired that fraudster. I'm not saying that you should regret your debt. I don't recommend shaming yourself for your past decisions. I'm simply asking, what would you have done differently? Was the debt worth it? Sometimes the answer to this question will be an enthusiastic "YES!" Maybe debt allowed you or a loved one to go on living, or at least spend some time together before your loved one died. Perhaps your business debt has returned itself 100 times over. It's possible that you plan to go into debt again. What you would have done differently may be instructive in helping you devise a debt payoff plan. Not only that, it instructs you on how to stay out of debt in the future. This is almost as important as paying off the debt to begin with. In a future guide on staying out of debt, I'll tackle this again. For now, its only important to know what behavior you could have changed. Now that you understand how past behavior contributed to current debts, let's help you make a real debt payoff plan. The framework for the next two steps comes almost directly from an old episode of Joshua Sheats podcast, Radical Personal Finance. Listen to the podcast if you want extensive details, but I've done my best to summarize and explain how I've helped others in the past. Step Three: Add up your debtWhether your a few hundred in debt or a few hundred million in debt, it pays to know how much debt you're dealing with. Now, organizing this information can be complicated. I recommend creating physical representations of your debts. Write out the total amount owed, to whom it is owed, the interest rate of the loan. If you're dealing with multiple millions of dollars of debts, and you owe more than 10 parties, this system isn't going to be sophisticated enough for making a plan. Still, it can be instructive. At the very least, enter the recommended information into a spreadsheet (or have your bookkeeper do it). Using a calculator or your spreadsheet, I recommend that you total the amount due. Let the number sink in for a bit. A lot of people feel shocked when they see how much debt they've accumulated. I think it's good to give yourself some time for emotion. If I could suggest a step three part b, it might be let the numbers sit for a day or two. You've done some emotionally exhausting work, and you might need a break. Step Four: Understand the terms of your debtYou know how much debt you're in, but do you really understand the debt. Making a great payoff plan requires that you understand how your debt is structured. The terms of your debt has several components, but these are the most important to consider:
Why do these questions matter? Well, everything held equal (including your behavior):
The terms of your debt matter! As you make your personalized debt payoff plan, consider the amounts of your debt and the terms. Step Five: Choose your most powerful behaviorNow that you have a good understanding of your debt, you need to understand what behavior you can change that will lead you to pay off your debt the quickest. These are the best options (that I can see).
A huge proportion of the population will pay off their debt through Big Wins or Focus, but those might not work for you. What will? Make a decision, so that you can take the final step. Step Six: Make a planOnce you're equipped with the knowledge and insights from the previous steps, a debt payoff plan will practically write itself. Maybe you do need to follow the snowball or avalanche plan. But maybe you don't.
Every person has different risks. People who itemize deductions should view debt differently than those who don't. People who will have their student loans forgiven should behave differently than those who won't. People who have assets can view debt differently than those who don't. It's always smart to understand the terms of your debt, and what debt poses the most risk to you. It's also smart to understand what plan will help you get the most traction. It's your debt payoff plan. Do what makes sense to you. These are a few tips as you make your plan.
Get organized, understand your incentives, and harness the power of the one behavior that will make the biggest difference in your life. You can do it! Let me know in the comments if I've missed anything.
21 Comments
Wow some really good advice in this post! I'm impressed at how detailed you got. I agree that a tailored plan is the only way. I am definitely guilty of pushing my "highest interest rate first" debt payoff strategy on others. But I've become more sensitive to the fact that personal finance is psychological, and debt is VERY psychological. So if you are going to feel 10x better paying off all debt regardless of interest rate, or knocking out some of the smaller loans first...so be it.
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9/29/2016 08:17:42 am
Another thorough and awesome post, Hannah. All of these steps helped us to start getting out of debt. Making a plan that fits your specific situation is SO important.
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9/29/2016 09:10:25 am
Great detail as always. Knowing why you had debt is so important...there's a big difference between paying down debt that's still accumulating because of your behaviors and paying down debt that was accumulated for a one off situation.
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I love the avalanche method of debt repayment but like you said, having a plan is better than having no plan at all so I don't really get involved in the debate because I know everyone's situation and needs are different. These are all great tips though and can really help people understand their current situation with debt so they can determine the plan of attack that suits them best.
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9/29/2016 09:08:20 pm
Really smart and detailed post. Like most financial advice, different people respond to different financial paths. I too use to push paying off your highest interest rate first. After learning the psychology of getting quick wins through the debt snowball, I then started to discuss with friends the impact of paying off a debt vs paying down the debt. It became more evident which method made more sense for them.
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10/3/2016 01:20:41 pm
Great advice, Hannah. I especially like your list of questions and considerations regarding the terms of your debt. I have to say, you thesis--"it depends, do what is best for your situation"--is the answer to so many of the PF debates of topics like earn more vs. spend less and others.
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10/8/2016 11:48:02 pm
Debt is such an enemy if used improperly. I see some of my friends who have a lot of student loan debt but they don't use the money towards that first, but pay themselves first. While that's all well and good I don't know how sustainable that will be if they prolong their 5 figure debt for so long.
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Planning is incredibly important when it comes to paying your debt! However, not one specific plan works for everyone! Like you said you have to understand why you're in debt and how to fix it, and this must be catered to you individually and not your neighbor or your co-worker because everyone's debt is different! Thank you so much for going into such depth with this article! It was a great read and very informative!
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Hannah
11/27/2016 05:01:19 pm
Glad to help, and I agree, everyone is different.
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10/29/2016 06:46:15 pm
I really enjoyed this post Hannah! Its really nice to see a guide to help others pay off debt from a different point of view.
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Hannah
11/27/2016 05:02:36 pm
Thanks Chonce!
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11/9/2016 10:55:42 am
Just excellent!
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1/14/2017 04:54:10 pm
I totally agree that there isn't any one size fit all approach when it comes to debt. However, I'd like to distinguish between good debt and bad debt.
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About HannahI'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life. Archives
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