The YourMoneyNumbers: Debt topic is the fourth in the YourMoneyNumbers (YMN) series. For more information on the YMN series, click here.
Debt — the four-letter word of personal finance. You may be surprised at why this topic is fourth inline instead of upfront and center. I want to ensure that you have taken a solid and balanced look at your overall personal financial situation before you address working on your debt. All too often, people jump into a solution that is not sustainable and then bounce right back into debt – and sometimes make the situation even worse than when you started. It is important to understand what you have and what you owe (Net Worth) and to make sure you have gotten your spending plan (Budget) inline (accounting for at least all minimum payments on debt). Then, as you make a plan to pay off your debt you know that if you stick to the plan, you will be successful in reducing your debt over time. Also, you will have established an emergency fund — to weather small emergencies without falling back onto debt as a solution (Check out Liquidity to learn more).
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I tend not to think of debt as necessarily “good” or “bad”– although there is a lot of high-interest rate debt out that is pretty bad. If you are responsible with debt, and it is at a low-interest rate, it can facilitate you achieving your goals. On the flip side, being free of debt (or having very little debt) can provide the freedom to change your goals without having the regular payment constraints that having debt imposes. The Quantify Financial (QF) approach assumes that you are looking to eventually eliminate your debt (possibly while saving or investing) and gives some thoughtful considerations to make as you progress on that journey.
What are YourMoneyNumbers related to debt?
Debt to Income Ratio
Percent of your monthly income you are required to pay to your debts
How to calculate: Refer to your Budget Sheet.
Sum of your total minimum monthly debt payments DIVIDED BY your average monthly income.
To calculate your percentage, multiply by 100.
Keep this below 36%
Why does this matter?
36% is typically the limit that traditional mortgage lending looks for to determine if you are worthy to lend to (some loan types allow for a slightly higher percentage).
Debt to Disposable Income Ratio
How to calculate: Refer to your Budget Sheet.
Sum the total minimum monthly payments for CONSUMER DEBT (not mortgage) and DIVIDE BY your average monthly take-home income.
To calculate percentage multiply by 100.
Here’s an idea of what your debt to disposable income percentage can tell you:
- Ideally below 10%
- Manageable at 15%
- Over-indebted 20%+
Why does this matter?
You want to drive this number down! This number represents the percentage of every hour you work that goes towards paying down debt (or financial decisions you have made in the past) – instead of investing in your future.
If your debt to disposable income ratio is greater than 20% it is considered over-indebted and you may want to get a professional to help assess an appropriate path forward.
Debt to Asset Ratio
How to calculate: Refer to your Net Worth Statement.
Total Liabilities divided by your Total Assets
To calculate percentage multiply by 100.
Why does this matter?
This metric represents what percentage of your assets would be required to be liquidated to cover your liabilities. If you track this value over time, you will hopefully see that your number may start high (very high if you have debt and little in assets), but will reduce over time once you have balanced your budget and have developed a debt pay-down plan. The number will be zero once your liabilities are fully paid-off.
This metric is also important when you are looking towards building wealth. You may be able to keep your Debt to Income and Debt to Disposable Income Ratio in the “green” if you are a high earner. If your net worth isn’t building over time, you will never really overcome the paycheck to paycheck cycle.
Time to tackle your debt!
Step 0: Before you do anything else!
Make sure you have completed the following before you consider how to optimize your debt payoff. (Keep paying AT LEAST the minimum payments on all of your debt throughout!!!!)
- Complete your net worth statement so you know what savings you have and exactly how much debt (liabilities) you have. (YMN #1: Net Worth).
- Make sure your monthly budget accounts for AT LEAST all the minimum payments for your debt. This ensures your basic spending levels do not continue to push you deeper into debt. (YMN #2: Budget)
- Save an Emergency fund of at least $1000 and make sure your total liquidity ratio is at least 1. (You have one month of expenses in liquid assets.) (YMN #3: Liquidity)
Consider getting help from an outside source if you are having issues completing Step 0. To make real progress with debt payment you need to be able to at least meet existing obligations and free up resources in your budget to help pay down debt. If you are concerned that your debts may be overwhelming and you may need to pursue bankruptcy, you will be required to meet with debt counselors in advance. You can find more information here:
https://www.consumer.ftc.gov/articles/0224-filing-bankruptcy-what-know
Step 1: Time to characterize your debt!
The good news is that you should have most of the information you need from when you created your liabilities list and your budget.
For each debt collect the following information:
- Total Remaining Balance
- Minimum Monthly Payment
- Current Monthly Payment
- APR (Annual Percentage Rate) – Different debts have different interest compounding methods and different terms. The APR is a standard way to express the actual cost of a loan over a year. It also lets you more easily compare interest rates between loans.
- Fixed vs. Variable – Does the amount owed stay the same each month (e.g., mortgage or car payment) or does it change based on the balance owed? To simplify debt repayment plans, you keep the minimum payment for variable accounts equal to the minimum payment at the time you set up the repayment plan.
- Secured vs. Unsecured – Mortgages or car payments are considered secured debt – if you default, the lender can pursue foreclosure or repossession of the car. Credit cards are typically unsecured.
The difference between the amount of your Current Monthly Payment and of your Minimum Monthly Payment are dollars that can be reallocated based upon your debt repayment, saving, and investing strategy. The same can be said if your average monthly income minus expenses is positive.
Step 2: Strategize an approach
The challenge with debt payoff is figuring out how to balance aggressive debt pay off with other financial goals. Followers of Dave Ramsey and the like would say to get out of debt before you do anything other than a modest emergency savings account. That approach might work for you. If debt stresses you out, or if following his method would get you out of debt in a matter of months, not years, I think it is something to consider. Being free from debt has many advantages – the most important in my opinion is flexibility. It is much easier to weather a job loss or reduction in income if you don’t owe anyone anything.
If your debt is large, and at a lower interest rate (e.g., some student loan debt), some would argue that by aggressively paying down that debt causes you to miss out on investing and gaining a higher return on your money. Investing early is when you can take the best advantage of compound interest. Here’s the thing that you have to balance: any return-on-investment you can achieve comes with some inherent risk associated with it (typically – the larger the return, the larger the risk). You might be able to average 8% returns by investing in the market over time, but there is risk associated with that investment and you could easily go down 10% or more in a given year. By paying off debt faster than your minimum balance plan (assuming there are no pre-payment penalties), you effectively get a guaranteed return (with no risk attached to it) of the interest rate on the debt.
So you need to find the right balance of debt repayment vs. savings and investment that will best serve your relationship with your money and meeting your financial goals.
I am not a fan of high-interest rate debt – think credit card debt (my threshold is > 6% APR). It would be very hard to find investments that would consistently outperform the cost of that debt (especially when considering risk). Credit card debt (even with a good credit score) – can be 14% or 17% up to 20%+ APR. For any debt repayment plan, I typically would say – get rid of the high-interest rate debt first – before you consider upping your contributions to saving or investing.
Once you get below the high-interest debt, I think there is room for you to make decisions based on your risk tolerance. If your debt repayment will last years (not months) – it is good to consider a plan that sets up habits for savings and retirement investing alongside debt repayment.
Here’s the problem – if you aren’t going to follow a “simple” rule-book for how you are going to tackle your finances (Dave Ramsay method, Suze Orman, etc.), you had better be sure that you aren’t fooling yourself into thinking you are in a better position when it comes to debt than you are. This is why I am a fan of knowing YourMoneyNumbers and looking at them regularly. If you are familiar with them, you can predict the impact of a financial decision on each of the numbers. If you understand the implications of your decision and are still completely comfortable making that choice – then presumably you are looking to use your money in a way that serves your values. If you are looking at debt without a clear plan on how it serves your savings, investing, or life goals – it is more than likely just a justification to spend more than your means. In these cases – look to create a new savings goal – prioritizing appropriately alongside the rest of your goals instead of taking on the debt.
Let’s look at a few cases:
Case 1:
You are a high earner, with a stable income, decently funded emergency fund (3-6 months), fully fund your retirement account, and want to take a 3% car loan (rather than paying cash and depleting the emergency fund). You have done the numbers and even with the car loan, your debt to disposable income ratio and your liabilities to assets ratio will still be in good shape. If buying this new or pre-owned car is of high value to you, this looks like it could be a good option for you.
Case 2:
You have a fully-funded emergency fund (12-24 months), fully fund your retirement and savings goals each year, and have really good credit. A family health situation has come up and you would like to remodel your basem*nt such that your mother can come live with your family. It would take you five years with your current income/spending to save to have the cash on hand to achieve this goal. The situation is pressing and you can secure a Home Equity Loan for 6%. In this case, you are trading the interest cost of borrowing the money against having the project done 5 years sooner. You could look to re-prioritize savings/spending over the next few years to pay off the debt more quickly, but if you are really good about managing your money and have a clear plan to pay off the debt, taking on debt may be a comfortable option for you.
Case 3:
You have a $1000 emergency fund and are paying off debt, but are not saving toward retirement. The car is not worth much but is reliable, and needs about $1000 of repairs. You fear that it will still need more repairs down the road. You are considering getting a new car that costs $25,000 with a 3.5% interest rate over 60 months. The payment would be $455 per month. In this case, when you look at the impact on YourMoneyNumbers, you would likely decide against buying the new car. Not only would adding the loan increase your liabilities and your debt to disposable income ratio, but it would slow down the debt repayment that you are working on. While spending the $1000 of your emergency fund would deplete it, it could be recouped within 3 months, and after that, you would be back on track for your debt payoff without an added $455 payment each month.
Case 4:
You are in your early 20s make $50,000 and have no high-interest rate debt. You have a $450 per month car payment @ 3.5% for 60 months. You have an additional $450 per month that could go toward paying down the car loan faster, building emergency savings, or contributing to your company 401(k), which has a 4% company match. In this case – since your debt to current disposable income is in the OK territory– I would look to using the $450 per month to start the habit of contributing to the 401(k) and building up your emergency savings fund. By building up the emergency savings before your expenses are high, you will be well situated for the future and will have established savings as a habit. The company match for the 401(k) is a nice benefit as well.
Caveats
I recognize that there are times when a life circ*mstance arises and taking on debt is the only option at that moment. If a medical concern must be addressed or your only transportation to your job completely breaks down and cannot be repaired — you may need to take a loan. I would strongly encourage you to try to understand the terms of these loans and to minimize them in whatever way possible. In these cases, don’t despair, it is time to regroup and replan. Set up a sustainable budget for moving forward. Re-prioritize your goals and start marching to the new plan.
Payoff Methods
There are so many different methods possible to pay off debt and they all have benefits and drawbacks depending on your situation. I will talk about a few of the main ones here.
Snowball
The snowball method is where you pay the minimum payments on all of your debts EXCEPT the one with the lowest balance. The intent here is that you take anything extra that you can throw at debt and pay off your smallest balance first. Then you can take the amount you were paying each month to the debt you paid off and add that to the minimum payment of the next lowest balance debt.
The benefit of the snowball method is that if you have multiple debts you reduce the number of debts you have quickly. The benefit is as you pay them off there are fewer bills to pay which can be more manageable AND you achieve some payoff successes early – a great motivator.
Avalanche
This method mathematically pays off your debts the FASTEST by tackling the highest interest rate debt first. You pay the minimum amounts on all debts EXCEPT the one with the highest interest rate. Once that debt is complete you apply the amount you were paying to that debt to the next highest interest rate debt.
Transition (Avalanche to Snowball)
I’m a fan of this approach, although it may be a little more complex. You pay any high-interest rate debt off first – similar to the avalanche plan. Once you get to lower interest rate debts, you snowball them to achieve quicker payoffs. It isn’t mathematically the most efficient, but it takes advantage of the avalanche method where it matters (high-interest rate debt) and then gives you the psychological benefits of the snowball method for lower interest rate debt.
Other Strategies
Refinancing
Refinancing is the process of restructuring your debt (either through your current lender or through another lender) for a lower interest rate, which should save you interest over the overall lifetime of the loan. There are typically refinancing fees that need to be considered to ensure that you are coming out ahead. You need to be aware of all of the terms of the refinance: APR, term, monthly minimum payment, etc.
Consolidation
Consolidation is taking multiple unsecured forms of debt and refinancing them into one debt with a single payment at a lower interest rate. The goal with consolidation is to simplify your debt payment, lower your overall minimum monthly payment, and/or reduce the overall interest rate. Make sure you fully understand the terms of any type of consolidation effort you pursue in the same way you would if you were refinancing.
CAUTION – many companies advertise that they can consolidate or “settle” your debt. In many cases, the terms of these “deals” may have you pay out less initially, but you end up paying out MORE over the lifetime of the loan. Also, debt settlement can be damaging to your credit score. Here are a couple of articles that discuss the benefits and pitfalls of debt consolidation and settlement.
https://www.consumer.ftc.gov/articles/0153-choosing-credit-counselor
https://www.consumer.ftc.gov/articles/0145-settling-credit-card-debt
Personal debt consolidation – If you have a good credit score, you may qualify for a personal line of credit and be able to consolidate your debt to one payment. This is less risky than using a third party. The terms should be easily available to you through the financial institution you are using.
Step 3: Track your Progress
Tracking your progress is a key component to staying on task. Seeing that you are moving toward your goals each month keeps you motivated to stick to your plan. Find ways that work for you! A couple of suggestions:
- You can track your liabilities over time in a spreadsheet – trending down is good!
- Create physical debt repayment diagrams where you color in to show progress for each dollar amount of reduced outstanding balance. This could be similar to the fundraising thermometers, only you are tracking how much debt you have paid down instead of how much money has been raised. Tailor to your situation: each increment could be $100 or $1000. Pinterest is a great source of inspiration – check out ideas for debt payoff worksheets.
- Use a tool to track progress! I have heard good things about the Vertex42 spreadsheet available online. For an on-line tool, look into the Undebt.it website (There is a demo account that you can try before actually signing up for your free account.). These tools provide comparisons of paydown methods, will tell you how much to pay toward each account each month to follow your debt payoff plan, and will predict when you will become debt-free.
Step 4: Celebrate the small successes
Another motivational technique: When you pay a debt off, or hit a major milestone in your debt repayment plan, treat yourself to something special. Don’t go too wild here, you don’t want to set yourself back with any progress you’ve made! It might be a nice dinner out or just an activity you have been looking forward to doing. If your debt repayment plan will take years and not months, you want to be able to celebrate along the way.
Summary
I hope that this article has helped you think about how to approach debt and debt repayment. By tracking your Debt to Income Ratio, Debt to Disposable Income Ratio, and Debt to Asset Ratios over time, you can see the progress that you make and have ways to evaluate the impact of your financial decisions to take on additional or pay off your debt.
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