Episode 38: What Works Wednesday: Debt

Welcome to this week's "What Works Wednesday" episode as Leland delves into the intricacies of debt management. Join us as we explore efficient repayment strategies, including the debt avalanche and debt snowball methods. Then, discover how to make informed decisions about allocating extra funds between debt repayment and investments. Don't miss out on this insightful discussion that could reshape your financial future. Tune in and take the first step towards financial freedom.

PeaceLink Financial Planning LLC

Transcript:

Hey everyone, welcome back to the Self -Employment Success Podcast. Today is What Works Wednesday. I'm your host, Leland Gross, and today we're going to be talking about debt. And two big questions I get a lot around that topic of different types of consumer debts. The first question is, what's the most efficient way to pay off your debt? And the second question is, how do I know if I should pay off my debt or save and invest? If I've got this money, do I

apply it to my student loans or do I invest the money? What do I do? So the first one, let's talk about efficient ways to pay off debt. And there's a couple ways to think about this. I would say there's really two strategies that I kind of fall back on. There are different ways you can do it, but there's two kind of solid strategies called the debt avalanche and the debt snowball. So.

They're pretty similar. Basically, you're going to line up all your debts. So your credit cards, your car notes, your student loans, you're going to line them all up. You're going to line up all the balances and then you're going to line up all the interest rates. Meaning I've got my credit card with $1 on it at 25%. I have my car note with, you know, $15 ,000 at 7%. I've got my student loans at $30 ,000 at 6%. Whatever it is, line them all up. And...

And then also line up what is the minimum payment for each of these things. Because no matter what strategy we're going to do, we're going to make sure you always pay the minimum payment bar none. Do not miss a debt payment because that is where you get into delinquency, default, it gets, you know, bad stuff. So when it comes to the avalanche or the snowball, it's really prioritizing what's the order we pay these down.

No matter what, you're going to be paying your minimum, but you want to be able to take a little bit of extra and apply it to one of them to really pay that one down first and then pay the next one and pay the next one. Because if you're just paying the minimum, you're going to stay in that cycle. And oftentimes with minimums, the interest rate continues to grow. And so your debt continues to grow and you kind of stay in debt forever. So you need to be making more than the minimum payment. But do we apply that evenly to all of them? Do we? Which ones do we choose?

With the debt avalanche, what you're going to do is you're going to find the loan with the highest interest rate, which will typically be your credit card. So you prioritize the highest interest rate and you put any extra that you're going to pay towards your debt onto that card, onto that debt line item. So everything's getting their minimum, but your credit card or whatever debt has the highest interest rate, you're going to prioritize. Pay that down. Once that's paid down and that's at zero, you're going to take everything you paid for that.

So whatever, if you were doing $400 a month onto it, you're going to take that 400 and you're going to add that to the next highest interest payment. So let's say it was the next credit card and the minimum payment on that was 100. You were paying 400 on the higher interest rate vehicle. Well, now we're paying 500 on the next highest line interest rate. So the debt payments bigger. So now you attack that one even faster. Once that's paid off, you take that 500 and you apply it to the next one.

So now you might be paying 550, 600. And so your monthly debt obligation payment stays the same. It's all the minimums plus, you know, the extra few hundred dollars that you're putting on, but we're prioritizing by highest interest rate so that those highest interest rates don't balloon. And as you're knocking those down and interest rates are getting lower, you end up paying it off pretty quickly. The other option is the debt snowball, which is the same thing.

except you're going to prioritize the lowest balance first. So if you have a debt that's, you know, 10 ,000 and one that's 1 ,000, you're going to pay off the $1 ,000 one first. And then you'd move up to the next one and you're not really going to worry about what the interest rates are. So the avalanche prioritizes interest rate. The snowball prioritizes balance. Now you may be asking, well, which one's best?

And it's hard. I've actually run financial plans where I've calculated that and depending on the situation, snowball could be faster or avalanche could be faster. So which one's the money one is dependent on the situation. But I will tell you that the snowball is actually psychologically better. It's more sustainable. So,

even though sometimes the avalanche on paper will get your debt down faster. The snowball oftentimes has more success in my opinion because of financial psychology. Now I haven't done like a huge study on that. I'm just looking at my client's experience. But what I find is when you're overwhelmed with debt, when debt payoff is your obligation, paying off a full line and having it off the

the spreadsheet or off the table feels really good. It's exciting to take that payment and move it to the next one and be like, boom, now I'm putting on 500 on my next one. We're going to pay that one down even faster because that's only a little bit higher. Then we're putting 700 on the next one. And so there's a psychological piece that says, I'm making progress because I had, you know, six loans and credit cards and now I only have five. I only have four.

And when you pay off those smaller ones quicker, you kind of get that endorphin rush that keeps you in the game. And then you get to a bigger payment on the bigger interest rate faster. So that's kind of why I tend to like that one with the avalanche. It's not a bad plan. It's a really good one. And again, sometimes paying off that high interest one loan first gets you out of that faster. But

Sometimes that one's also the biggest loan. Sometimes it takes a while to just chip away at that. And when you're making all these other minimum payments, you're not putting as much capital to that specific vehicle every month. And so it can just be a slog sometimes. So even if long term you get out of debt a little bit faster, psychologically, it's a lot harder because you're not seeing as much tangible progress as quickly. Then with the snowball where...

you're seeing progress happen on these lower value debt obligations that then those payments progress to the bigger ones. So debt avalanche, debt snowball, both great options to look into if you're someone who's struggling with debt or whose main goal maybe for 2024 is to get out of debt. Look into both of those, begin calculating them. There are great tools online if you just Google.

I didn't come up with avalanche and snowball. If you just Google it, they're real strategies and there's lots of tools out there to help you do that. The second question I get is, you know, I've got my debt under control, but you know, I'm making payments on it, but I get, let's say a tax refund or a gift, or we just have extra money coming in. Should I put that on my debt or should I put that on my into investments and grow it?

There's a lot of differing thoughts. Some people would say, always put on your debt, you're a slave to debt, get out of debt, debt is bad always, that should always be your number one priority. I don't know that that's my thought necessarily. That's not my philosophy. And so I would say the true answer is it depends, which is like the worst financial advisor answer. I feel like you ask an advisor anything and they just say it depends, but it's true because it's so personalized. So when I say it depends, I want to tell you what I mean by that.

I function on net worth. And if you need a definition on net worth, go back a couple episodes, another What Works Wednesday kind of defines it and defines why it's important. But the high level answer is that's your clearest vision or touch point on financial health. That is your speedometer for financial health. That's going to tell you my financial engine, my financial house is in order. If your net worth is positive and it's growing.

And so when we make decisions, it's not just investment or debt. What do those mean to you? How much are those impacting you? It's what is going to move the needle on your net worth? How are we actually going to grow your wealth over time? And growing wealth comes from paying down debt and from saving. So if you lower your debt, your net worth goes up. If you save and invest, your net worth goes up. If you take on debt,

your net worth goes down. If you get rid of a bunch of money, you spend it, your net worth goes down. And our goal is to have the net worth go up. Now, that's basic. In real life, you know, you got a credit card with an interest that's raising your debt, but you're putting payments on debt, but then you're saving and investing over here. Everything's fighting on your net worth. It's a tug of war. So when it comes to, hey, we have this money, what are we going to do with it?

we have to look at what's actually going to move the needle on your net worth the best way possible. So that may mean, hey, you've got credit card debt and that's at 25 % interest. There is not an investment out there that's going to guarantee you 25 % interest. This credit card is guaranteeing that. That credit card is working against your net worth. It's lowering your net worth by 25 % of the credit card balance every year.

Whereas your investments in a good year, they may hit that, but they're going to average long term according to the S &P 500, you know, anywhere from 8 to 12 long term. So we don't, we do not want in that situation, we would want to apply it to your credit card because the interest on that is hurting your net worth more than the growth on your investments are helping your net worth. Now let's flip the script.

I have my mortgage at, you know, two and a half percent from 2021. And then I've got my investment account that's growing on average at 10%. Well, in that case, I'd say your mortgage interest is not hurting your net worth. Your investment account is really benefiting it. So let's pay, let's invest that money that way. Or, you know, I've got a personal loan at 5%, but I, you know, have

a fixed income vehicle who's guaranteed an interest rate of 6%. Well, the 6 % is going to be the 5%. So you want to look at which one is vying for your net worth the most. And do we need to invest or do we need to pay off the debt based on that? If the debt is growing more than your investments, then your debt is growing more than your savings and your net worth is falling. If the savings and investments are growing more than your debt,

Well, then you're going to get a better bang for your buck. Let's just pay off your debt over time and invest that money. This is the same reason why you see wealthy, wealthy, wealthy people, the ultra high net worth, who take out mortgages on their properties. There's a celebrity recently who mortgaged an $80 million home. They had the cash to pay for it. They could just pay cash and not have to worry about the mortgage payment on $80 million.

But they knew and they were in an interview saying the interest rate on that mortgage was lower than what I could make on my investments elsewhere. So of course I'm going to mortgage it. I've got the cash flow to pay for it. I'd rather be putting my money somewhere where it's going to grow more than that mortgage interest is going to grow.

not to mention that interest for them because it would naturally be higher than the standard deduction would help them from a tax perspective, disclaimer. So there were some tax benefits to that. But that's kind of how I think about it. So if you were sitting there, if you're my client and we're saying, you know, do we pay off debt or do we save and invest? We look at the picture, we say, what are your debts? What are the interest rates on them? What are the savings and investments we need to be doing or we want to be doing? And what's going to get you further down the field?

And typically we make that decision based off of the interest rates or the growth. So I hope that helps. Look into the avalanche and snowball. Look at your debts and investments and see, you know, which one's vying for your net worth the most and apply it there. And with that, go forth, build the life you want and prosper.