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?
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
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 debt
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 debt
The terms of your debt has several components, but these are the most important to consider:
- What is the interest rate?
- Is the debt secured or unsecured?
- Is the interest on this debt deductible?
- Can this debt be refinanced?
- Is this debt bankruptible?
- Will the interest rate change (balloon) in the future?
- If my interest rate will change in the future, will I owe "back interest" on the debt? This is common with X months interest free financing deals.
- Am I making progress in paying down principal?
- How long will it take to pay off the debt if I pay minimum payments.
Why do these questions matter?
Well, everything held equal (including your behavior):
- Higher interest rates hurt your net worth more than lower interest rates.
- Defaulting on secured debt will hurt you more than unsecured debt.
- You would want to pay off non-deductible interest debt before deductible
- You may want to refinance the loans to a better term.
- You would prioritize non-bankruptible debt over bankruptible debt.
- Ballooning debt represents future risk. We're in a low interest rate environment now, but the future can change. If your interest rate goes up, your minimum monthly payment will increase. Can you handle that?
- Owing back interest stinks. It's nice to avoid that if possible.
- If you're not making progress towards principal, you will literally never be debt free unless you pay more than the minimum payments.
- From a cash flow perspective, it's easier to make minimum payments for a short time than a longer time.
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 behavior
- Big Wins: Sell the house, sell the car, sell everything in sight, put the tax return or another windfall to your debt and set reset on your life. If you've got a net worth above zero, this might be a good option for you. Imagine, life without debt is within reach. With even moderate planning, you can avoid taking on consumer debt again. Big wins are how most of my debt free friends became debt free. This process cuts the debt payoff time to just a few months.
- Focus: If you don't have significant assets, you can cut expenses and raise your income in a focused manner. Harness the power of focus by choosing a debt snowball or a debt avalanche. This method works best if your debt to income ratio is less than 2. Even with a great plan, you can't easily sustain focus for more than a few years, so this is for average people, with average consumer debts who need to make an above average change. You can do it!
- Income: If you've gotten into a huge debt load, and you have "deal-making" ability, you need to use those abilities to generate huge income gains. This is for the Donald Trump, Dave Ramsey, and other crazy business folks who end up in 7+ Figures of debt from stupid deal making. Yes, you need to cut back on lifestyle, but you really, really, really need to make a lot of money.
- Bankruptcy protection: I advocate being a person of your word, but sometimes a combination of bad luck and bad decisions coalesce into an unsolvable problem. We don't have debtors prison. If you can't pay back your debt (maybe you had brain cancer but no health insurance), the United States has laws to protect you. Bankruptcy isn't some walk in the park, but if it's your best option, go for it.
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 plan
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.
- If you need to harness focus, choose the debt snowball or the debt avalanche. If you want to do the math about which is better for you, use this calculator on Magnify Money.
- Back interest is horrible. If you don't plan to pay that off before it's due, make a plan to refinance.
- If you should refinance, get your credit to good or excellent first. Then, Refinance debts as quickly as possible. Consolidating to a low interest credit card, a personal loan, or a balance transfer card makes sense in some situations.
- Move quickly and decisively on your plan. Harness your emotion against debt and the powerful behavior you previously identified to put your plan into action.
- If you fall off the bandwagon, get back on sooner than later.
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.