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 debt
Whether 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 debt
You 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 behavior
Now 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 plan
Once 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.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.