Dealing With Debt, Part 3

Debt is like a slippery slope–you can slide down very easily but if you want to climb back to the top it can feel almost impossible. High risk debt is such a slope. What exactly is high risk debt? It’s any debt that has an interest rate that can go sky high if you don’t pay it back.  Examples are cash advances, payday loans, monies owed to the IRS and collections, and credit card debt (the most common type and primary focus here). These debts, with their high interest rates, and their ability to give consumers a headache are the primary reason that most of America operates their households in a deficit.  It is hard to get ahead in your savings if all your capital is going to fill the pockets of your credit card company through your interest payments.  

 

Debt Elimination Strategies 

 

A common question I get when discussing paying down debt is, “should I pay off my debt completely before I start investing into my emergency fund or saving into my 401(k)?” The answer to that is, “It depends.”  Mathematically, a major wealth building principle is to make sure that interest is always working for you and not against you. If you are earning 2% in an emergency fund but paying 15% in credit card debt it makes numerical sense to pay off that credit card debt first.

 

However, if we spend all of our days paying down credit card debt and continue to see a big fat zero on the savings account we can suffer what I like to call “fiscal fatigue”. There is something about seeing growth in your savings account that gives someone motivation to keep going. 

 

So when determining whether or not to pay down your high risk debt, or to invest into your emergency fund and 401(k) the answer is probably to do a little of each.  After you have done your budget and determined that you have a $200 surplus (money left over after all expenses are paid), a 50%/25%/25% split could be appropriate. With 50% ($100) of your funds going towards your credit card debt, 25% ($50) going towards your 401(k) (or possibly more if your company matches), and 25% ($50) going towards building your emergency fund in a high yield savings account.

 

The Snowball Method

 

One of the best ways to pay down your debt is the snowball method.  This method is established by using all or the majority of your budget surplus to “attack” the small item of debt owed. After you eliminate this debt, your surplus is increased by the minimum payment of the recently eliminated smallest debt, and you use your newly enhanced budget surplus to pay down the next smallest debt owed…and so on. This method essentially allows you to build momentum as you pay, gives you motivation to continue, and forces you to organize your debt efficiently.  

 

Hopefully by now you have organized all of your debt. Fill out all of your debt in the grid below from the largest amount owed to the smallest owed:

 

Company Owed Phone Number Mailing Address Due Date Minimum Due Balance Owed Line of Credit Interest Rate
Bank 1 XXXX XXXX 1/15 $50 $4000 $5000 13%
Bank 2 XXXX XXXX 1/15 $75 $2000 $3000 7%
Bank 3 XXXX XXXX 1/15 $100 $1000 $3000 10%
Bank 4 XXXX XXXX 1/15 $50 $400 $1000 10%

 

In the snowballing method, once you have organized your debt, make sure that you have a sound budget to calculate your monthly surplus (the amount of money you have left over after all of your expenses are paid).  Your budget should include within it the minimum due of each monthly debt.  

 

Using the above example, let’s say that you have $200 left over after expenses to comprise your entire monthly surplus. You take the $200 and apply it to the LOWEST AMOUNT OWED.  In this example you would pay down “Bank 4” debt by an extra $200. After two months of paying an extra $200 per month to your Bank 4 debt you will have paid down the $400 and eliminated the Bank 4 debt.  Now you have an extra $50 free because the minimum due on the Bank 4 debt was $50 and your entire surplus increases by $50 to $250.  

 

Now you need to apply the $250 to “Bank 3” debt.  After four months of paying $250 to Bank 3 that debt will be eliminated. Your surplus increases by $100 (the minimum due on Bank 3) and you now have a total of $350 which can be applied to the debt owed to “Bank 2.”  After about 6 months the Bank 2 debt will be eliminated and you now should have a $425 surplus ($350 previous surplus + $75 minimum due on Bank 2 debt). In approximately 9 – 10 months, paying $425 towards the debt owed to “Bank 1,” and if you add the minimum due of that debt to your total surplus you will then have $475 per month to invest in other areas.  

 

If you notice Bank 1 has the highest interest rate, but is the last to be paid off completely. That’s okay– I have found that the progress that people see and feel by actually eliminating debt, is worth more in motivation than the extra money being paid in interest. When someone can physically see a bill eliminated, it gives them a sense of accomplishment.  Now, if you feel that you would rather organize your snowball strategy and pay your debt down from highest interest rate first, that is your call. Just be aware of that “fiscal fatigue” that can come into play when you are paying the same debt down for months and still have multiple bills to be paid off. Either way, just keep in mind you are doing the best thing possible for your financial health.

 

Marriage and Money Part 1

Marriage and Money Part 2

Marriage and Money Part 3

Dealing With Debt – Part 1

Dealing With Debt – Part 2

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