Debt is a word that makes a lot of people uncomfortable. We don’t like to think about our debts, much less talk about them. We have all made poor financial decisions, whether out of recklessness or ignorance, but that doesn’t make you or your situation hopeless. One of the greatest issues I face with new planning clients is openness and transparency with debts and financial missteps. Many clients are embarrassed of their situation and want to withhold information, even though that situation is the very reason they came to me in the first place. Ignoring or hiding your debts won’t make them go away (just ask collections agencies!), so you might as well face them head on. The purpose of this article is to discuss what it means to pay down your debt versus saving or investing, the different schools of thought on debt management, and how to create a budget that meets your needs.
What Does It Mean To Pay Down My Debt?
Most debts have a minimum payment, consisting of two parts: principal and interest. Your payment is first applied to the interest due, and the remainder goes to reducing the principal (which in turn reduces the interest applied on the next cycle). Of course, once the principal reaches zero, you no longer have to pay on that debt. Apart from the minimum payments on your debts, you can do 3 things with the remainder of your money: 1) spend it, 2) pay down debts further, or 3) save/invest. Making this decision is important and can have enormous impact on your financial future.
Let’s assume you recognize the importance of not spending all your money (option 1) and decide to put some of your money towards increasing your net worth (both options 2 and 3 accomplish this). If you invest your money in the market, you will get a variable rate of return (stocks have historically returned about 8-10% per year, but with enormous variability). However, by paying down your debts, you get a guaranteed “return” that is determined by your interest rate. In other words, if you pay off $100 of debt financed at 10% today, you are guaranteed to save yourself $10 over the next year, whereas there is no guarantee of getting a $10+ return in the market in that same time frame. This means that debts with a higher interest rate (credit cards) should be paid off first, since you get the best guaranteed “return”. Think of this as another form of diversification, just like investors diversify their portfolio with different asset classes.
Should I Pay Down My Debts Faster Or Invest?
There are two main schools of thought on this subject: pay down all your debts as quickly as possible, or pay the minimum and invest the difference. People that gravitate toward the former tend to be very anxious about debt or just generally risk averse, while people that choose the latter tend to be overly optimistic about the market. There are pros and cons to both approaches; the debt-first approach means that individuals will be debt-free sooner and will have more control over their cash flow, but the saver will have better liquidity if an emergency situation arises and needs cash in a hurry to avoid going further into debt. Both are tempting, but neither are ideal. Knowing which route to take can be tricky so that is what we will tackle next.
Implementing A Debt Management Strategy
Let’s say you have $100 left over each month that you would like to go toward increasing your net worth (ideally, you would want to be putting 10-20% of your after-tax earnings toward this strategy!). Let’s also say you don’t have much saved, either in checking/savings or investment accounts, and you have a fair amount of credit card debt. In this case, take half of the money ($50) and apply it to your highest interest debt. Take the remaining $50 and put it into checking/savings. Once you have 1-3 months of earnings saved, start putting that money into a taxable brokerage account until you have another 3-12 months of earnings saved (younger people should be on the low end of this range, pre-retirees should be on the higher end). Once you have sufficient cash reserves built up, you can start putting that money toward more tax-efficient retirement accounts or use it to pay down debt even faster. Again, that decision will be influenced by the interest rates on your remaining debts, along with your age and attitude toward your debt. The higher the interest rate and the closer you are toward retirement, the more money you want to put towards debt. Below is a cheat sheet to help you determine what portions of your excess cash flow should go towards debt and what should be invested. I hope this helps clear up some confusion about debt management and budgeting toward a debt free retirement. I tried to keep this as simple as possible, but the truth is that so much of this depends on your own personal financial situation, and there is no such thing as a perfect one-size-fits-all approach. This article merely provides guidelines to help you make your own informed decisions.
|Highest Interest Rate on Debt||Probability of Long-Term Market Outperformance||% That Goes Toward Debt|
This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at firstname.lastname@example.org.