How Do I Work Out of Debt?

Owing people money (debt) sucks. A friend of mine, much closer to retirement than I, once told me that "debt is just a part of life for everyone. It's inevitable." This is the debt experience for most American families. 77% of Americans are in debt, in the form of credit card debt, student loans, home mortgages, or other types. But just because debt is commonplace doesn’t mean it’s inevitable or that you can’t get out of it.

First, let’s acknowledge that not all debts are created equal. Some debts are worth carrying to the end of their term, while others should be paid off swiftly.

The decision to carry versus eliminate certain debts is best determined by comparing debt interest rates to expected investing rates of return while accounting for your debt tolerance. Use the following as a guideline when deciding whether to keep or get rid of the debt you carry.

• Debt interest rate is less than 3% – pay it off slowly (making just the minimum payments) and invest your additional money

• Debt interest rate is between 3-10% – do what you're most comfortable with, between debt paydown and investing (if you decide not to pay off the debt in this range, your extra money should be invested)

• Debt interest rate is over 10% – pay off the debt as quickly and as violently as possible

You can follow these guidelines regardless of what the debt is for because of the historic average returns of the stock market. An additional $100 put toward a 3% mortgage, car, etc. would save you less money than a $100 investment in an S&P 500 Index Fund would earn you based on historical data (past gains do not guarantee future results).

Personally, Em and I chose to eliminate all of our debt besides our home mortgage (that sweet, sweet 2.5% interest rate), which we plan on paying off slowly while investing heavily. Your risk and debt tolerance should influence your decision.

Get to the Point, Mike

Alright, now that we’ve established what debts you should pay off aggressively, let's address how to do so.

Debt paydown starts with mindset. Your debt paydown period should evoke a level of focus and intensity that rivals the dudes at the arcade crushing Dance Dance Revolution (IYKYK).

The key to debt paydown is to pick a focus debt and apply all your available money toward that one debt while continuing minimum payments on all your other debts. Once the first debt has been paid off, apply all available money (including the money originally put toward the minimum payment on your first debt) to the next debt. Continue this until you’re debt-free!

It’s that simple. Not easy, but simple. For those with multiple sources of debt, the order in which you pay them off can influence how long it takes and how much money you’ll pay in interest.

Debt Avalanche vs. Debt Snowball

There are two common strategies for focused debt paydown: the debt avalanche and the debt snowball. The debt avalanche method involves paying off your debts from the highest interest rate to the lowest rate (i.e., 12%, then 8%, then 5%). The debt snowball method advocates paying off debt from the smallest debt balance, by dollar value, to the largest (i.e., $100, then $500, then $750).

Of the two, the debt avalanche is the better option (sorry, Dave Ramsey). You’ll pay off your debts quicker and you’ll pay less money in interest than with the debt snowball.

This isn’t to say that the debt snowball doesn’t have its perks. By quickly paying off your smallest debts, you’ll free up cash flow quicker than you would with the debt avalanche, benefitting those with immediate cash flow needs. Also, paying off your smallest debt balances quickly with the debt snowball can give you the quick dopamine hits to motivate you to keep crushing your debt.

However, I’m more motivated by keeping more of my money and killing my debts faster (point for debt avalanche).

If you still decide you're choosing the debt snowball, I propose a compromise. Pay off your smallest debt balance first to get that first big win, free up some additional money by knocking that payment out, and boost your confidence in your debt-slaying abilities. After you pay off your first debt, switch to the debt avalanche method to pay less in interest and shorten the length of your debt paydown period.

The Debt Lasso (Break Glass In Case of Emergency)

But wait, there’s more. Introducing the debt lasso, the lesser-known cousin of the debt snowball and debt avalanche. The debt lasso involves refinancing all high-interest credit card debt into lower (or zero) interest credit cards and personal loans to reduce your debt payments. The "lasso" part of the name refers to the consolidation of different credit card debts into as few places as possible.

DISCLAIMER: This strategy should only be considered if you have multiple sources of high-interest and large-balance credit card debt that you can't manage to put a significant dent in, regardless of how much money you throw at them. A comfort for and ability to handle added complexity and a strong dose of willpower is also a must.

Pros: You can save money on interest, expedite debt paydown, and eliminate variable-interest rate credit card debt.

Cons: It can become overly complicated, riddled with potential transfer fees and fine print that can sabotage your efforts. Having poor credit can limit your low-interest rate options for transferring credit card balances. Worst of all, if managed unwisely, this method can reinforce carrying debt indefinitely by jumping from one low-interest credit card or loan to another.

For those seriously committed to debt paydown, the debt avalanche method can quickly and efficiently eliminate debt without the need for added complexity. I introduce the debt lasso, not as the primary credit card debt paydown solution for most people, but to bring awareness of the option as an added tool in your tool belt.

Debt sucks, but it doesn’t have to plague you forever. Look your debt in the face and develop a plan to rid yourself of it. Trust me, you’ll sleep better when you do.

Call to Action:

List your debts and identify which ones you want to pay off quickly vs. carry through their full term. Stack the debts you want to pay off quickly in order from highest interest-rate to the lowest. After investing up to your employer’s match, use the debt avalanche to begin eliminating your high-interest rate debt.

What We’re Reading/Listening To:

Afford Anything #430 - Ask Paula: My Parents Are Drowning in Credit Card Debt. What Should I Do?

Debrief on Deck:

Next week, I’ll cover the different levels of FIRE (Financial Independence Retire Early) so you can pick which retirement option best suits your desired lifestyle.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (Twitter and Instagram).

Until next time, stay the course.

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