There is a good chance you, or a close family member, carry debt. It’s common for the typical American household to carry amounts exceeding six figures (Tsoie & Issa, 2018). Debt can be mysterious in the sense that individuals might owe a similar amount, but perspectives on how to repay debt vary dramatically. Debt is also not always negative and can provide strategic benefits in your financial plan. Consider a home mortgage for example, the underlying asset is likely to increase in value. Mortgages often offer a valuable source of leverage, but loans on depreciating assets like cars can quickly end up with negative equity. Other loans, like high interest credit card debt, can be especially menacing. This article will focus on consumer debt repayment and we will highlight a few common approaches to help the borrowers make real progress on eliminating debt.
Many households across the country have debt related to auto loans, credit cards and even personal loans. The decision to take on debt is personal and the need or desire for debt means different things to just about everyone. Below are some common questions to consider when developing a debt repayment plan.
How do you organize debt?
Which debt should be paid first?
Should debt be paid off ahead of investing for retirement?
One strategy that many people find effective for debt elimination is using rolling payments. Rolling payments involves focusing on aggressively paying off one loan at a time, while making the minimum payments on other debt. With rolling payments, you throw as many excess dollars in your budget as possible toward repaying one loan. Once the target loan is paid off, roll that loan payment into paying off the next debt beyond the monthly minimums. Keep rolling your payments to the next loan on your list until the ball and chain of your bad debt is paid in full. To illustrate a couple different ways to prioritize your debt list, we are going to look at three approaches for prioritizing debt, including, an interest rate approach, a behavioral approach and a combination strategy that factors in retirement savings.
When evaluating debt repayment from an interest rate approach, order all debts from highest interest to lowest, and attack the highest rate first. Focusing on interest rates makes sense because you are reducing the debt with the highest interest rate drag. Although progressive, the downside to this approach is that it might take months or even years until you finally check a loan off your list. Many people become worn out and lose motivation to follow the plan. There will also be cases where a loan with a lower interest rate, but larger balance will be more impactful on the overall repayment plan than a small loan with a higher rate. However, prioritizing debt strictly by interest rates ignores that.
Interest Rate Approach Example
Let’s meet Steve, who has three outstanding debts. Steve has student loans totaling $22,000 at 6%, a car note of $15,000 at 3.5% and $8,000 of credit card debt at 17% annual interest. Utilizing the interest rate approach, Steve will prioritize his debts according to the table below and use the rolling payment method, we discussed for repayment.
Illustrating the Behavioral Approach
Now let’s consider Steve’s situation from the behavioral approach. This behavioral method prioritizes starting with the smallest loan regardless of interest rates. Compared to the interest rate approach, you will likely end up paying more interest overall with the behavioral strategy, but the small wins along the way provide motivation and reason to celebrate. This method has been popularized by the personal finance personality, Dave Ramsey, who consistently recommends focusing on behavior. He refers to this approach as the “debt snowball”. You can still take advantage of rolling payments with the behavioral strategy, so once each loan is paid off, roll the payment to the next debt on the list.
Combining Perspectives: Debt Repayment and Retirement Savings
The power of compounding interest reveals its best to contribute early and often towards retirement savings for maximum growth. If your debt is not too overwhelming, it can be valuable to continue retirement savings while paying down loans. With this in mind, we can utilize a combination approach that addresses both debt reduction and retirement savings. One method is to target either a specific debt reduction or savings goal. Use your primary goal as a minimum benchmark then throw as many extra dollars in the other direction (debt or savings) as possible. Combining goals of retirement savings and debt elimination is best utilized when loan interest is less than the expected return of investments for retirement. Focusing on both savings and paying off debt can be helpful for identifying opportunities to “beat the spread” by investing versus paying off debt.
No matter how you decide to repay debt, take comfort in knowing the best strategy is one you can commit to and stick with during tough times. Here at Merriman, we believe in the power of committing to a sound plan for guidance throughout your financial life. If you’re lost on where to start, please take a few minutes to read First Things First by Geoff Curran, which provides a guide toward prioritizing your savings. If you have questions or would like to learn a bit more, please contact a Merriman advisor who can help navigate your specific situation.
Tsosie, C., & Issa E.E. (2018, December 10). 2018 American Household Credit Card Debt Study. Retrieved from https://www.nerdwallet.com/blog/average-credit-card-debt-household/
Editor’s Note: Below is an article published first at MarketWatch that was written by Elaine Scoggins, CERTIFIED FINANCIAL PLANNER(TM) and director at Merriman
Early in my career, I knew a wealthy man who took his own life. He left a suicide note saying he was pushed to the breaking point trying to pay back some sizeable business and personal debt.
From the outside, he appeared to have it all: a successful business, a beautiful new luxury home, expensive vacations and a wonderful, loving family. But, like with so many people we’re impressed by, no one knew about the dangerous levels of debt he’d taken on in order to have all those things.
I use this story knowing it is an extreme case. Debt, in the right amounts and at the right times in our lives, can be very beneficial in helping us get ahead. But if you get into a situation where you can’t pay it back, it can turn out to be one of the ugliest nightmares you’ll ever face.
You might think that if the lender says you’re fine to borrow the money, it must be OK to proceed. But there’s one gigantic problem with those income and debt ratios that are commonly used to screen us all before we borrow: They assume nothing in your life is going to change.
Taking the time to honestly answer these five questions could save you from years of misery.
An article in the Wall Street Journal (Debt Hobbles Older Americans, 9/7/11) paints a sobering picture of the impact that rising debt levels have on people’s retirement plans.
Thirty-nine percent of households headed by people aged 60 through 64 had primary mortgages in 2010, up from 22% in 1994. The median value of mortgage and home loan debt, adjusted for inflation, for homeowners aged 60 to 62 also increased, from about $40,000 in 1994 to $80,000 in 2008.
Housing price declines have made it more difficult to pay off these mortgages, forcing people to work longer before retiring.
This article in The New York Times (Lewin, Tamar, “Burden of College Loans on Graduates Grows”, April 12, 2011) speaks about the growing total level of college debt, which is a function of increasing college costs, increasing numbers of students going to college and the increasing numbers of those students who need to borrow to attend school.
The article goes on to state that two-thirds of those who received bachelor degrees graduated with debt in 2008, compared with less than half in 1993. In 2010, the average loan amount for those graduates finishing college with debt was $24,000.
Attending college is great for its own sake, and also leads to substantially higher lifetime earnings and lower unemployment. However, both parents and students should consider the incremental costs and benefits of attending, for example, an expensive out-of-state private university instead of an in-state public university. Both might give the student a fine education, with good prospects for future potential graduate schools and/or jobs.
The private school might have more prestige. The question is whether this is a sufficient inducement to incur large amounts of debt which could negatively impact the retirement plans of the parents or the future lifestyle of the student. There is no right answer to this, but it is certainly something our clients can discuss with their financial advisors.
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