Originally published June 2021
Updated November 2022
Debt - most of us have it.
While debt can be an excellent tool to achieve major milestones like a college education or a home purchase, it can also be corrosive to your financial health and stability.
And very few "regular folks" have ever been educated on how to deal with debt optimally.
In my ongoing quest to bring good financial advice directly to you, this month I'm taking on debt.
How much debt is too much? How should you pay your debt down?
Is there such a thing as a healthy level of debt? When is it OK to take on more debt?
Let's jump in!
How Much Is Too Much?
Some people will tell you that even one dollar of debt is too much.
I don't subscribe to this notion, and neither should you.
Having said that, there are a few ways to think about debt levels.
- Cash Flow: If your monthly debt payments make it hard for you to meet your other needs, you may have too much debt.
- Net Worth: If your debts outweigh your assets (giving you a negative net worth), you may have too much debt.
- Debt Ratios: If the ratio of debt payments to your gross income is more than 43%, you may have too much debt.[1]
- Gut: If you're simply uncomfortable with the level of debt you have, you may have too much debt.
If you've decided you have too much debt based on these parameters, you're likely now wondering how to dig yourself out.
How Should I Pay Down My Debt?
There is no one “right way” to get out of debt. But there are a handful of approaches that will help you optimize how you go about dealing with debt.
Cash Flow Method
If the major issue for you is cash flow, the best course of action is to look at each monthly debt payment.
Choose the biggest debt payment and focus on paying it down first.
Continue making minimum payments on all your other debts, but focus your efforts on getting rid of that biggest payment first.[2]
For example, say you have a student loan with a $320 monthly payment, a credit card with a $30 monthly minimum payment, and an auto loan with a $260 monthly payment.
Using the cash flow method, you would pay $30 on the credit card, $260 on the car, and focus on paying the student loan as quickly as possible.
If cash flow isn’t the major issue, it’s best to prioritize your debt by the cost — that is, the annual interest rate.
Interest Rate Method
Identify the annual interest rate associated with each debt, and rank order them from highest to lowest.
Identify the annual interest rate associated with each debt, and rank order them from highest to lowest.
Looking back at our previous example, let’s say the student loan has an interest rate of 5.25%, the credit card is at 23%, and the auto loan is at 3%.
In this case, you would pay $320 a month on the student loan, $260 a month on the auto loan, and as much as possible on the credit card.
Lastly, if you’ve got negative net worth or simply don’t like the level of debt you have, there is a third method.
Snowball Method
You can pay off the smallest balance first and work your way up.
Back to our example.
The student loan has a balance of $30,000, the credit card has a balance of $1,500, and the auto loan has a balance of $12,000.
Using this method, you would pay off the credit card first, then the auto loan, and then the student loan.
Using Debt Wisely
As I mentioned above, I disagree strongly with the notion that having any debt at all is bad.
Debt can be used as a tool to further key financial goals, while preserving our ability to invest for other goals.
For example, let’s assume you want to pay off your student loans in one fell swoop right now, or start paying them down faster than you’re scheduled to.
And let’s assume that doing either means you would not be able to make regular contributions to your retirement savings accounts.
Every dollar that you fail to invest now is a dollar that can’t grow over time.
When time is on your side, compounding is the most powerful force in the universe.
In addition, it may cost less to borrow that dollar than the return you can expect to get over time.
Say that you are a risk-seeking investor and your expected average annual return is 8%.
The cost to borrow these student loans is closer to 5.25%. So, you're paying 5.25% to borrow, but earning 8% when you invest - which means you could be (on average) nearly 3% to the good.[3]
When considering whether to pay off existing debt early or take on new debt, consider these things:
- Am I able to afford the payments on the debt I have?
- If I take on new debt, will I be able to afford those additional payments?
- What is the opportunity cost of investing a dollar vs. borrowing that dollar?
- Will taking on this new debt cause my net worth to become negative, my debt payments to equal more than 43% of my gross income, or a feeling of unease about money?
In my opinion, debt can either be a force for good in your life (if used responsibly) or a big source of stress (if it gets out of control).
There is a balance to strike when using debt to optimize your financial situation.
A good Financial Advisor will help you navigate your debt in the context of your larger financial plan, enabling you to get the most from every dollar you work so hard to earn.
If you need help filling out the worksheet or want to learn more about how a financial advisor can help you manage your debt, book your free one-hour consultation.
[1] This metric is used by mortgage lenders to assess a potential borrowers overall fitness to borrow and is a widely used metric to assess overall debt levels.
[2] Here I’m excluding mortgage payments. More often than not, a mortgage is a cost of living and not something you should focus special effort on paying down. However, there are exceptions to every rule of thumb. If paying off your mortgage loan may enable you to reach other goals sooner, it may be worth a deep dive analysis with your Financial Advisor.
[3] The math in your situation may be different depending on the cost of your debt and your ability to tolerate risk.
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