- Jonathan McCarty, CFP®
Debt Battle Plan
Debt is tricky. On one hand, debt can be a tool you deploy to accelerate financial growth; just like a financial institution does, we can utilize debt to help us get multiple turns on a single dollar. On the other hand, for many it can be (and feel) like a literal mountain standing in the way of your path to financial success.
In my career, I’ve engaged with many clients specifically to craft a battle plan for their debt. Now, the debt can exist for any variety of (good or bad) reasons – student loans, business loans, consumer debt, etc. Regardless of where the debt comes from, the principle is the same:
"If you don’t create a proactive plan for attacking your debt, you’ll operate under the agenda of the lender, who would prefer to stretch that debt as long as possible to charge the maximum amount of interest possible."
Ralph Waldo Emerson said “A man in debt is so far a slave”. He may sound a little dramatic, but his point should not be missed.
So, what is the best battle plan for you? Apologies for the leading question; obviously the answer is “it depends ”. There are several ways to skin this cat and your approach will largely depend on your own circumstances. However, there are some guiding principles we can discuss:
Know What You Owe
A smart person once said, “the best way to get something done is to begin.” Well, we can’t begin to craft a battle plan until we know the enemy. To get started, we need to have a clear understanding of exactly what we owe, and to whom.
A great way to accomplish this in 2018 is to use a financial aggregator tool. For our clients, we rely on a program called JB Wealthbuilder.
If you’re old school, you can build out your debts into a spreadsheet – make sure you track the loan origination date, number of payment periods, interest rate and payment amount.
Know What You Make
Yes, Captain Obvious, we need to know what you’re bringing in to be able to know what you can afford to lay out in your debt strategy.
If you don’t know what you make each year… who are you? Just kidding. Kind of. Grab a recent pay-stub and multiple the “net amount” (after taxes & benefits) by the number of pay periods in a year. This will give you a rough idea of your net income. Or, if you’re really enterprising, grab last year’s tax returns.
Know What You Spend
This is another place where an aggregator tool can really help you – they will typically draw in all of your spending and automatically categorize it for you so you can easily diagnose where the money is going.
We need to know what your core living expenses are – mortgage, insurance, taxes, food, transportation and etc.
We also want to know what your discretionary expenses are – things that could be cut or reduced – like entertainment, cable, memberships, subscriptions, etc.
Obviously, when we’re trying to find money to use towards debt, we pull from these discretionary areas.
Emergency Fund First
Once you have a good understanding of your current position- you know what you owe, you know what you make & what you spend- our last “hurdle” is to make sure we have adequate emergency savings.
If we don’t, and life throws us a curveball (and it will), then we’re going to end up borrowing more and exacerbating our debt problem.
A general rule of thumb – for double and single income households – is to have 3-6 months of core living expenses saved up. So, if your core living expenses are $5,000 per month, we would suggest $15,000 - $30,000 in your savings before you embark on a debt pay-down program. The more volatile your income, the more you should have set aside.
Three Common Strategies:
Debt consolidation is a popular “fix” for many debtors. Typically, when you consolidate, you see your monthly debt payment go way down. Hence the attractiveness....
However, you need to be careful here because you could end up playing into the lender's hands when you consolidate.
There are two reasons your payment normally goes down under a consolidation: you get a lower overall interest rate (good) and a longer payment period (probably not good).
So, you think you’re saving money by going in at a lower rate, but if you end up stretching the debt out even farther you wind up paying much more in interest over the life of the loan. It’s good to remember the rules of financial institutions.
Consolidation can be useful if we’re not meaningfully extending the payment periods of your loans (as a whole), or if you’re able to see meaningful savings in the interest rates. After all, if you can lock in a lower rate with consolidation you’re not required to extend the term, you’re simply tempted to. Small difference in vernacular but for some people the same meaning.
1) Lower interest (normally)
2) Lower minimum payment requirements
3) Simplicity – everything in one place
1) Temptation to extend loan term, thereby increasing interest paid
This is perhaps the most popular and most successfully implemented debt paydown strategy. Results come quickly, and confidence is built early on. Assuming you’ve completed the prior steps (knowing thyself, emergency fund), this is how it works:
Figure out how much extra you can throw at your debt each month; let’s say its $300
Send that $300 towards your smallest debt until it’s wiped out
Once the smallest debt is wiped out, take the $300 plus whatever the smallest debt was costing you and pay it towards your next smallest debt.
Rinse & Repeat
So, you maintain the minimum payments on all of your other accounts while all of your “extra” money is attacking your smallest debts first. As you wipe out those smaller debts, you free up more money each time to attack the next debt on the list. Ergo, the snowball effect.
1) Easy to implement & understand
2) Results are quick which builds confidence – because we attack the small guys first
3) Will almost always shorten the payment period of your loan portfolio
1) Does not pay any attention to interest rates on the individual loans, which may cause you to pay more in interest than other strategies
Much like its better-known cousin, the debt avalanche is a progressive debt pay-down strategy. In this scenario, however, we order our plan of attack based on the interest rates on each of the loans. So, regardless of how big a loan is, we attack them in order of which loan has the higher rate. In practice:
Figure out how much extra you can afford to use each month; let’s keep the same $300
Send that $300 towards your highest interest debt until its wiped out
Once that debt is eliminated, take the $300 plus the payment you just wiped out and apply it towards the next highest interest debt.
Rinse & Repeat
So, the aim of this model is to minimize the overall interest you pay on your loan portfolio as you eliminate the debts.
Easy to understand & implement
Almost always the lowest total interest cost of any debt strategy
Can be slow to develop and cause frustration – sometimes the higher interest debts are large and take a while to pay off
All of these strategies will take you to the same destination – a debt free balance sheet. Don’t miss the forest for the trees though; there is such a thing as good debt and bad debt. It you go nuclear here and eliminate every scrap of debt on your balance sheet (like a low interest mortgage for example) you could actually be creating some lost opportunity cost for your financial future.
We have lots of experience in crafting a custom-built plan of attack for our client’s debt. We’d love to connect with you to learn more about your personal situation and start planning out your battle.